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CE40 ENGINEERING ECONOMY DIRECT MATERIALS

ENGR. CHENNIE CARISSA A. CAJA
chennieccaja@gmail.com
COST CONCEPT AND DESIGN ECONOMICS
Direct raw materials refer to any materials
that are used in the final product and that can
be easily traced into it. (Example: wood in
furniture, steel in bridge construction, paper
in printing firms, fabric for clothing
manufacturers)

Note that the finished product of one

In business,
company can become the raw materials of
cost is
another company. (Example: computer chips
usually a
produced by Intel are raw materials used by
monetary
Dell computer in its personal computers)
valuation of
effort,
material,
DIRECT LABOR
resources,
time and Direct labor labor costs that go into the
utilities production of a product. (Example: labor
consumed, risks incurred and opportunity costs of welders in metal fabricating
forgone in production and delivery of a good industries, carpenters or bricklayers in home
or service. building, machine operators in various
manufacturing operations)
Costs are generally divided into two:

1. Manufacturing costs
2. Non-manufacturing costs MANUFACTURING OVERHEAD

Manufacturing overhead include all costs of

MANUFACTURING COSTS manufacturing except direct materials and
labor. Unlike direct materials and direct labor,
Most manufacturing companies divide
it is not easily traceable to specific units of
manufacturing costs into three broad
output. Many manufacturing overhead costs
categories:
do not change as output changes, as long as
1. Direct materials the production stays within the capacity.
2. Direct labor (Example: indirect materials, indirect labor,
3. Manufacturing head maintenance and repairs on production
equipment, heat and light, property taxes,
depreciation, insurance of manufacturing
facilities, and overtime premium)

NON-MANUFACTURING COSTS

There are two additional costs in supporting

any manufacturing operations:

1. Marketing or selling costs include all

costs necessary to secure customer
orders and get the finished product or
service into the hands of the customer.
2. Administrative costs

Overhead heat and light, property taxes,
depreciation or similar terms associated with
its selling and administrative functions
Marketing advertising, shipping, sales travel,
sales commissions, and sales salaries
Administrative functions executive
compensation, general accounting, public
relations and secretarial support
STANDARD COSTS
Standard costs planned costs per unit of
output that are established in advance of
actual production or service delivery. They are
developed from anticipated direct labor
hours, materials and overhead categories.
Standard costs are used in the following:
Estimating future manufacturing costs
Measuring operational 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 work in
process and finished inventories
CLASSIFICATION OF COST FOR PREDICTING
COST BEHAVIOR
In engineering economic analysis, it is
important to predict how a certain cost will
have in response to a change in activity. Cost
behavior describes how a cost item will react
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or respond to changes in the level of business
activity. These costs include:
1. FIXED COSTS costs unaffected by
change in activity level over a feasible
range of operations for the capacity or
capability available. (Example:
insurance and taxes on facilities,
general management and
administrative salaries, license fees and
interest costs on borrowed capital)
2. VARIABLE COSTS costs associated
with an operation that varies in total
with the quantity of output or other
measures of activity level. (Example:
costs of materials and labor used in a
product or service)
3. INCREMENTAL COSTS (or
incremental revenue) are additional
costs that result from increasing the
output of a system by one (or more)
units.
COSTS CONCEPT RELEVANT TO DECISION
MAKING
1. OPPORTUNITY COST potential
benefit that is given up as you seek an
alternative course of action
2. SUNK COST one that has incurred in
the past and has no relevance to
estimates of future costs and revenues
related to an alternative course of
action.
3. LIFE-CYCLE COST summation of all
the costs related to a product,
structure, system or service during its
lifespan.
Basic Life-cycle cost categories:
Investment cost (or capital
investment) is the capital required for
most of the activities in the acquisition
phase
Working capital funds required for
current assets that are needed for the
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start-up and support of operational
activities.
Operation and maintenance cost
(O&M) include many of the recurring
annual expense items associated with
the operation phase of the life cycle.
Disposal cost include nonrecurring
costs of shutting down the operation
and the retirement and disposal of
assets at the end of the life cycle.

THE GENERAL ECONOMIC ENVIRONMENT

The goods and services that are produced and
utilized may be divided into two classes:
1. Consumer goods and services
products or services that are directly
used by people to satisfy their wants.
(Example: food, clothing, homes, cars,
television sets, haircuts, medical
services)
2. Producer goods and services used to
produce consumer goods and services
or other producer goods. (Example:
Machine tools, factory buildings, buses,
farm machinery)
As the selling price per unit (p) is increased,
there will be less demand (D) for the product,
and as the selling price is decreased, the
demand will increase.
The relationship between price and demand
can be expressed as a linear function:
=
where a is the intercept on the price axis, and
-b is the slope. It follows, of course, that
= ( 0)

Many of our business activity, including BREAK-EVEN ANALYSIS

engineering, focuses on increasing the utility
(value) of materials and products by changing Break-even analysis involves investments of
their form or location. capital wherein at a certain level of
production, the total income of the company
UTILITY power to satisfy human wants and would just be equal to the total expenses,
needs, most commonly measured in terms of thus, resulting in no loss nor profit.
value, expressed in some medium of
exchange as the price that must be paid to
obtain the particular item.

Goods and services may be divided into two

types: (a) necessities and; (b) luxuries.

For all goods and services, there is a

relationship between the price that must be
paid and the quantity that will be demanded
or purchased.

TOTAL REVENUE FUNCTION
The total revenue, TR, which will result from a
business venture during a given period is the
product of the selling price per unit p and the
number of units sold D. Thus,
= = When total revenue and total cost are
The relationship between price and demand
is,
The maximum total revenue can be obtained
by:
=
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COST, VOLUME AND BREAKEVEN POINT
RELATIONSHIP
Fixed costs remain constant over a wide
range of activities, but variable costs vary in
total with the volume of output. Thus at any
demand D, the total cost, is
= +
For linear relationship assumed here,
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=
where Cv is the variable cost per unit.
Scenario 1: Demand is a function of price
combined, the typical results as a function of
demand are depicted in the figure.
Notes;
At breakeven point D1, total revenue is equal
to total cost, and an increase in demand will
result in a profit for the operation.
Then at optimal demand D*, profit is
maximized.
At breakeven point D2, total revenue and total
cot are again equal, but additional volume will
result in an operating loss instead of a profit.
Example 1
A company produces an electronic timing
switch that is used in consumer and
commercial products. The fixed cost is
Php730,000 per month, and the variable cost
is Php830 per unit. The selling price per unit is
p=1800-0.2D. For this situation:
a. Determine the optimal volume for this
product and confirm that a profit
occurs (instead of a loss) at this
demand.

b. Find the volume at which breakeven
occurs; that is, what is the range of
profitable demand?
Answer: (a) D=2,425 units, (b) range of
profitable demand is 932 to 3,918 units per
month
Scenario 2: Price is independent of demand
When price per unit p for a product or services
can be represented more simply as being
independent of demand and is greater than
the variable cost per unit cv, a single
breakeven point results. Then, under the
assumption that demand is immediately met,
total revenue (TR)=pD.
Based on the definition of breakeven and on
the given assumptions,
= the professional staff. The variable cost is
= + charge-out rate is Php855.60 per hour. The
Example 2
A firm has the capacity to produce 1 million
units of a product per year. At present, it is
able to produce and sell only 600,000 units
yearly at a total revenue of Php720,000.
Annual fixed cost are Php250,000 and the
variable cost per unit is Php0.70.
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a. Calculate the firms annual profit or loss
for this production.
b. How many units should be sold
annually to break-even?
c. If the firm can increase its sales to 80%
of full capacity, what will its profit or
loss be assuming that its selling price
and variable cost per unit remain
constant?
d. Draw a breakeven chart indicating the
above results on the chart.
Answer: (a) Php50,000, (b) 500,000 units, (c)
Php150,000
Example 3
An engineering consulting firm measures its
output in a standard service hour unit which
is a function of the personnel grade levels in
Php620 per standard service hour. The
maximum output of the firm is 160,000 hours,
and its fixed cost is Php20,240,000 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 by 10%; if variable
cost per hour is reduced by 10% and if
the charge-out rate per hour is
increased by 10%?
Answer: (a) 85,908.32 hours or 53.69% of their
annual capacity, (b) 10%, 20.83%, 26.64%

PRESENT ECONOMY STUDIES
When alternatives for accomplishing a
specific task are being compared over one
year or less and the influence of time on
money can be ignored, engineering economic
analyses are referred to as present economy
studies.
Rule 1: When revenues and other economic
benefits are present and vary among
alternatives, choose the alternative that
maximizes overall profitability based on the
number of defect-free units of a product or
services produced.
Rule 2: When revenues and other economic
benefits are not present or are constant
among all alternatives, consider only the
costs and select the alternative that
minimizes the total cost per defect-free unit
of product or service output.
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be made by highly-trained workmen working
individually. The device can also be made by
highly less-skilled workmen working together
if they are given specialized equipment and
proper supervision. The highly-trained
workmen are paid Php20.00 per hour, and
each can produce one unit every 2 hours, on
the average. The specialized equipment can
be places in operation at an original cost of
Php60,000 and it will be worthless at the time
all the 5,000 units are manufactured. With
this equipment, four men, paid at Php15.00
each per hour, and a foreman, paid at
Php25.00 per hour, can do the work. All the
five men working together can finish one unit
in 15 minutes. Determine the gain or loss if the
specialized equipment is used.
Answer: The manufacturer can save
Php33,750 if the specialized equipment is
used over the highly-trained workmen.

Example 4 Example 6

Selection of Material Site Selection

A diesel engine uses Type A filter and high- A certain masonry dam requires 200,000
grade lubricating oil costing Php5.50 per liter. cubic meters of gravel for its construction.
With this filter, the oil and the filter have to be The contractor found two possible sources for
changed every 500 hours of operation, and 5 the gravel with the following data:
liters of oil have to be added every 100 hours. Source A Source B
This filter costs Php148 per piece. Eighty liters Average 3.0 km 1.2 km
of oil fill the engine. Another type, filter B, distance
costing Php120 may be used with a lower (gravel pit to
grade of oil costing Php4.80 per liter. dam site)
However, if this filter is used, the oil and the Gravel cost Php10.00 Php10.00
filter have to be changed every 300 hours and (per cu. m)
10 liters are added after each 150 hours the Purchase P800,000 -
engine is used. Which type of filter and oil price of pit
would you recommend? Road Php450,000 -
construction
Answer: It is more economical to use Type A necessary
filter and oil. Overburden - 90,000 cu.
to be m
removed (at
Example 5 Php4.20 per
cu. m)
Selection of Method Hauling cost Php4.00 Php4.00
per cu. m-
A manufacturer has a contract to produce km
5,000 units of a certain device. The device can
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Which of the two sites will give lesser cost? a. How many more men should the
contractor add so that he can complete
Answer: Source B
the work on time?
b. If of the additional men, 2 are paid
Php280.00 a day and the rest at
Example 7 Php220.00 a day, would the contractor
Economy of Tool and Equipment save money by employing more men
Maintenance and not paying the fine?

A machine used for cutting materials in a Answer: (a) 24 men, (b) The contractor will
factory has the following outputs per hour at save Php67,500 if he will employ enough
various speeds and requires periodic tool men, than paying for the fine.
regrinding at the interval cited.

Output per
Speed Tool regrinding
hour
A 200 pieces every 8 hours
B 250 pieces every 7 hours
C 280 pieces every 5 hours

A set of tools costs Php1,800 and can be

ground 20 times. Each regrinding costs
Php18.00 and the time needed to regrind and
change tools is 1 hour. The machine operator
is paid Php28.00 per hour, including the time
the tool is changed. The tool grinder who also
sets the tools to the machine is paid Php25.00
per hour. The hourly rate chargeable against
the machine is Php54.00, regardless of
machine speed. Which speed is the most
economical?

Answer: Speed C

Example 8

Economy in the Utilization of Personnel

A contractor has a job which should be

completed in 100 days. At present, he has 80
men on the job and it is estimated that they
will finish the work in 130 days. Of the 80 men,
50 are each paid at Php220.00 a day, 25 at
Php280.00 a day, and 5 at Php350.00 a day.
For each day beyond the original 100 days, the
contractor has to pay Php500.00 liquidated
damages.