Lngineering

Lconomy
Chapter 2
Cost Concepts and the Economic Environment
1he objectie o this Chapter
is to analyze short-term
alternaties when the time
alue o money is not a actor.
Categories o Cost
Fixed cost
unaffected by changes in activity level, e.g. insurance and
taxes on facilities, license fees, interest costs on borrowing
capital etc.
Variable cost
vary in total with the quantity of output (or similar measure
of activity)
Incremental cost
additional cost, or revenue resulting from increasing output
of a system by one (or more) units
Direct
can be measured and allocated to a specific work activity.
e.g. material cost.
Indirect
difficult to attribute or allocate to a specific output or work
activity (also overhead or burden).
e.g. cost of equipment maintenance etc.
Standard cost
cost per unit of output, established in advance of
production or service delivery.
e.g. direct labor hours.
Categories o Cost ,cont`,
Cash cost
a cost that involves a payment of cash.
Book cost
a cost that does not involve a cash transaction but is
reflected in the accounting system.
Sunk cost
a cost that has occurred in the past and has no relevance to
estimates of future costs and revenues related to an
alternative course of action.
e.g. R&D cost, cost of buying a machine few years ago and now the
machine has worn off
Categories o Cost ,cont`,
Opportunity cost
the monetary advantage foregone due to limited resources.
The cost of the best rejected opportunity.
Life-cycle cost
the summation of all costs related to a product, structure,
system, or service during its life span.
Categories o Cost ,cont`,
Lie Cycle o Cost
Why analysing Life Cycle Cost (LCC)
What do I need now and how much will it cost me for a
project?
What will I need to do in the future and how much will that
cost me?
How long is the future?
How do I evaluate future costs vs current costs?
Divided into 2 phases:
Acquisition phase
Operating phase
Stages in Lie Cycle Cost
6 stages involve:
3 stages in acquisition phase
3 stages in operation phase
1. Analysis
planning a project/propose an idea in produce a new
product/design etc.
Analysis include the economy needs for the product, system,
structure of service
2. Research and development
Conceptual ideas turn to preliminary design
Development on feasible alternatives
With engineering analysis, preferred alternative will be
selected
Prototype testing to support preliminary design
3. Design and planning
Detail design or planning for production or construction
Prepare operational facilities and other resources
4. Production or Construction
production, delivery, or construction of the end item or
service
5. Customer service or maintenance
6. Retirement and disposal
Retirement from active operation or use
Disposal of physical assets
Phases of the Life Cycle and Their Relative Cost
General Price-Demand Relationship
demand for a product or service
is directly related to its price
p = a - bD
Where,
p = price
D = demand
a = intercept on the price axis
b = constants that depend on the
particular product or service.
o Price high, demand will decrease
1otal Reenue
Total revenue (TR) is the product of the selling price per
unit ( p) and the number of units sold (D).
TR = price x demand = p (D)
Maximum Reenue
TR = aD bD
2
Solving the derivation, the
optimal demand is
To guarantee that D maximizes
total revenue, check the second
derivative to be sure it is negative:
d
2
TR/-dD
2
= - 2b
Profit is achieve when total revenue (TR) > total cost
(C
T
)
Profit (loss) = Total Revenue Total Cost
Where,
TR = aD bD
2
C
T
= Fixed cost (C
F
) + Variable cost (C
V
)
C
V
= variable cost per unit (c
v
) x demand (D)
Maximum Proit
Profit (loss) = Total Revenue Total Cost
= (aD - bD
2
) - (C
F
+ c
v
D)
= -bD
2
+ (a - c
v
)D C
F
Where,
and a > 0 , b > 0
For profit to occur:
1. (a - c
v
) > 0
2. TR > C
T
b
a
D 0
Number of demand (D) needed to achieve maximum profit:
To verify the maximum profit, second derivative must achieve
negative value:
0 2
) profit (
= = bD c a
dD
d
v
b
dD
profit d
2
) (
2
2
=
b
c a
D
v
2
*

=
Breakeven point, D
1

Total revenue = total cost

Increase in demand result in profit
Optimum demand, D*
Profit is maximised
Breakeven point, D
2

Total revenue = total cost

Additional volume result in loss
Reenue,Cost Breakeen.
Reenue,Cost Breakeen.
Breakeven is found when,
total revenue = total cost
aD bD
2
= C
F
+ c
v
D
-bD
2
+ (a - c
v
)D - C
F
= 0
Solving the breakeven point D
1
and D
2
(the root of the equation),
demand (D) to achieve breakeven can be obtained
) ( 2
) )( ( 4 ) ( ) (
'
2
b
C b c a c a
D
F v v

=
Single breakeven point can
be achieved when:
1. price (p) is independent from
demand (D)
2. Price is greater than cost per unit
(c
v
)
1utorial Question 1
A company produces an electronic timing switch that is used in
consumer and commercial products made by several other
manufacturing firms. The fixed cost (C
F
) is $73,000 per month,
and the variable cost (c
v
) is $83 per unit. The selling price per
unit is p = $180 0.02 (D), based on the optimal value of D that
maximizes profit. For this situation
a) Determine the optimal volume for this product and confirm that
a profit occurs (instead of a loss) at this demand; and
b) Find the volumes at which breakeven occurs; that is, what is the
range of profitable demand?
1utorial Question 2
An engineering consulting firm measures its output in a standard
service hour unit, which is a function of the personnel grade
levels in the professional staff. The variable cost (c
v
) 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
hours per year, and its fixed cost (C
F
) 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, and
b) What is the percentage reduction in the breakeven point
(sensitivity)
i. if fixed costs are reduced 10%
ii. if variable cost per hour is reduced 10%
iii. if both costs are reduced 10%
iv. if the selling price per unit is increased by 10%?