MSE604 Ch. 2 - Cost Concepts - Design Economics (Revised)

Engineering Economy
Chapter 2: Cost Concepts and Design

Economics
Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
The objective of Chapter 2 is
to analyze short-term
alternatives when the time
value of money is not a factor.

Costs can be categorized in several
different ways.
• Fixed cost: unaffected by changes in activity
level (insurance , taxes)
• Variable cost: vary in total with the quantity of
output (or similar measure of activity) such as
labor and used material cost.
• Incremental cost: additional cost resulting
from increasing output of a system by one (or
more) units , such as: cost of extra mileage on
a rental car.
More ways to categorize costs
• Direct: can be measured and allocated to a
specific work activity such as cost of
material used or labor.
• Indirect: difficult to attribute or allocate to a
specific output or work activity (also
overhead or burden), such as cost of tools,
equipment maintenance.
• Standard cost: cost per unit of output,
established in advance of production or
service delivery (planned cost)
Some useful cost terminology
• 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. (irretrievable
consequences, such as a non refundable
down payment)
More useful cost terminology
• Opportunity cost: the monetary advantage
foregone due to limited resources. The cost of
the best rejected opportunity (lost opportunity
cost).
• Life-cycle cost: the summation of all costs
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 acquisition phase begins with an analysis
of the economic need or want – the analysis
necessary to make explicit the requirement for
the product, structure, system, or service.
• The conceptual design activities translate the
defined technical and operational requirements
into a preferred preliminary design.
– Development of the feasible alternatives and
engineering economic analyses to assist in
selection of the preferred preliminary design

– Advanced development and prototype-testing
activities to support the preliminary design work
– Detailed design and planning for production or
construction
• In the operation phase, the production,
delivery or construction of the end item(s) or
service and their operation or customer use
occur.
– This phase ends with retirement from active
operation or use and, often, disposal of the
physical assets involved.
– The priorities for engineering economy studies
during the operation phase are:
1. achieving efficient and effective support to operations,
2. determining whether (and when) replacement of assets
should occur, and
3. projecting the timing of retirement and disposal
activities.

The General Economic Environment
Consumer and Producer Goods and Services
• Consumer goods and services are those

products or services that are directly used by
people to satisfy their wants.
• Producer goods and services are used to
produce consumer goods and services or other
producer goods.
Measures of Economic Worth
• Goods and services are produced and desired
because they have utility – the power to satisfy
human wants and needs.
• Utility is the most commonly measured in
terms of value, expressed in some medium of
exchange as the price that must be paid to
obtain the particular item.
Necessities, Luxuries, and Price Demand
• Goods and services may be divided into two
types: necessities and luxuries.
• What one person considers a necessity may be
considered a luxury by another.
• 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.
The general price-demand relationship
The demand for a
product or service is
directly related to its
price according to
p=a-bD
where p is price, D is
demand, and a and b are
constants that depend on
the particular product or
service.
Competition
• Most general economic principles are stated
for situations in which perfect competition
exists.
• 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.
• Monopoly is at the opposite pole from perfect
competition.
• A 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.

Total Revenue Function
Total revenue depends on price and

demand.
Total revenue is the product of the selling price per

unit, p, and the number of units sold, D.

Calculus can help determine the demand
that maximizes revenue.
Solving, the optimal demand

is

Cost, Volume, and Breakeven Point
Relationship
Total Cost = Fixed cost + Variable cost.
CT = CF + Cv
Cv = cv.D
where CF is a fixed cost such as the setup cost, Cv variable

cost, and cv is the cost/item such as the price of the items.

Scenario 1: The price is not fixed
(a function of the demand)

We can also find maximum profit…
Profit = revenue - cost, so

Profit (loss) = (aD-bD2) - (CF+cvD)
for
Differentiating, we can find the value of D that maximizes

profit.

And we can find revenue/cost
breakeven.
Breakeven is found when total revenue = total cost.

Solving, we find the demand at which this occurs.

Scenario 2: The price is fixed
(not a function of the demand)

Total revenue (TR) = p.D
Total Cost (CT) = CF + Cv = CF +cv.D
Profit = TR-CT
Note:
The slope of TR = p
The slope of CT = Cv
In general:
p > Cv
Otherwise, it is a loss.

The breakeven point is found at the demand (D’) as follows:
TR = CT
pD’ = CF + cv.D’
D’ = CF / (p-cv)’

Engineers must consider cost in the
design of products, processes and
services.
• “Cost-driven design optimization” is critical

in today’s competitive business
environment.
• In our brief examination we examine
discrete and continuous problems that
consider a single primary cost driver.
Two main tasks are involved in
cost-driven design optimization.
1. Determine the optimal value for a certain
alternative’s design variable.
2. Select the best alternative, each with its own
unique value for the design variable.
Cost models are developed around the design

variable, X.

Here is a simplified cost function.
where,
a is a parameter that represents the directly varying cost(s),
b is a parameter that represents the indirectly varying cost(s),
k is a parameter that represents the fixed cost(s), and
X represents the design variable in question.

Optimizing a design with respect
to cost is a four-step process.
• Identify the design variable that is the primary cost
driver.
• Express the cost model in terms of the design variable.
• For continuous cost functions, differentiate to find the
optimal value. For discrete functions, calculate cost
over a range of values of the design variable.
• Solve the equation in step 3 for a continuous function.
For discrete, the optimum value has the minimum cost
value found in step 3.

Example

“Present economy studies” can ignore
the time value of money.
• Alternatives are being compared over one year or
less.
• When revenues and other economic benefits vary
among alternatives, choose the alternative that
maximizes overall profitability of defect-free
output.
• When revenues and other economic benefits are
not present or are constant among alternatives,
choose the alternative that minimizes total cost per
defect-free unit.
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 – 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 – 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
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.
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.
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

Make Versus Purchase (Outsourcing) Studies
• Opportunity costs may become significant when in-
house manufacture of an item causes other production
opportunities to be foregone (Eg. insufficient capacity)
• In the long run, capital investments in additional
manufacturing plant and capacity are often feasible
alternatives to outsourcing.


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Engineering Economy

Chapter 2: Cost Concepts and Design

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Consumer and Producer Goods and Services

• Consumer goods and services are those

Copyright ©2009 by Pearson Education, Inc.

Total revenue depends on price and

Total revenue is the product of the selling price per

Copyright ©2009 by Pearson Education, Inc.

Solving, the optimal demand

Copyright ©2009 by Pearson Education, Inc.

where CF is a fixed cost such as the setup cost, Cv variable

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Profit = revenue - cost, so

Differentiating, we can find the value of D that maximizes

Copyright ©2009 by Pearson Education, Inc.

Breakeven is found when total revenue = total cost.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Total Cost (CT) = CF + Cv = CF +cv.D

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

• “Cost-driven design optimization” is critical

Cost models are developed around the design

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

Rules for Selecting Preferred Alternative

1 – When revenues and other economic benefits are present

Alternative Machine Speeds

Copyright ©2009 by Pearson Education, Inc.

Copyright ©2009 by Pearson Education, Inc.

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