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Chapter 2 - Cost Terminology and Design

Economics

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Cost terminology
Fixed, variable, and incremental costs
Fixed costs that remain constant over a specific range of
operating conditions. It is subject to change when larger
changes in the operating conditions involved such as plant
expansion or shutdown.
Variable costs that vary in total with the output units, e.g.,
material cost.
Incremental costs are the additional costs that result from
increasing the output level by one or more units.

Recurring and nonrecurring costs


Recurring Costs are those that are repetitive and occur
when an organization produces similar goods or services
on a continuing basis, e.g., variable cost and also a periodic
fixed cost like office rent.
Nonrecurring Costs are those that are not repetitive, e.g.,
construction cost of the manufacturing plant.

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Example 2.1

Fixed
Raw mtl.s
Direct labor
Rent
Admin. salaries
Utilities
Property tax
Property set up

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Variable

Recurring

Nonrecurring

Cost terminology
Direct, indirect (overhead), and standard costs
Direct costs that can be attributed to a specific activity or
output, e.g., labor and material costs directly associated
with the a product.
Indirect costs that cannot be attributed to a specific activity
or output. Normally, they are allocated through a selected
formula, such as by proportion, to the outputs or work
activities. Cost of common tools is an example of the
indirect costs.
Standard costs are planned costs per unit of output that are
established in advance of actual production. The standard
costs play an important role in cost control and other
management functions. One typical use is to measure
operating performance by comparing actual cost per unit
with the standard unit cost.

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Cost terminology
Cash and book costs
Cash Costs that involve payment of cash and would result
in a cash flow.
Book Costs that do not involve cash transaction and is
reflected in the accounting system as a noncash cost, e.g.,
depreciation.

Sunk costs
Sunk Costs are those that have occurred in the past and
irretrievable.
Sunk costs are not relevant in the engineering economic
analysis because they cannot be changed regardless of
what decisions is made now or in the future.
The original cost of an equipment is considered to be the
sunk cost for a firm in deciding to replace it or not.

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Cost terminology
Opportunity cost
The opportunity cost is incurred because there are only
limited resources available.
The opportunity cost of the selected alternative is the value
of the next best alternative opportunity that is forgone
(given up).
The value of the next best alternative opportunity that is
forgone can be obtained as the answer of the following
question:
"What would you gain if you selected the best alternative
opportunity instead of the choice you are considering ?"
The opportunity cost is forward looking in that it measures
the value that the decision maker sacrifices at the time the
decision is made and beyond.

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Cost terminology
Opportunity cost - Example 1
Suppose you have $2,000 in your bank account, you can either
keep it in the bank or invest it in stock market.
What is the opportunity cost of investing in stock market?
You will earn the accured interest of $2,000 if you choose to
keep it in the bank instead of investing it in stock market.
Therefore, The opportunity cost of investing in stock market is
the accured interest of $2,000.
Remark:
By the forward looking nature of the opportunity cost, $2,000 is
not counted into the opportunity cost since it has already been
existed before the time of making decision.

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Opportunity cost - Example 2


Option 1: Continue your own business with the annual expense
of $180,000;
Option 2: Stop the business and go out to earn $75,000 per
year.
What is the opportunity cost of continuing in business over the
next year ?
If you choose option 2, the amount of benefit you gain
= earn $75,000 (the income you earn for choosing Option 2) +
$180,000 (the amount you save for choosing Option 2)
= $255,000.
Therefore, the opportunity cost of continuing in business over
the next year is $255,000.

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Cost terminology

Life-cycle cost is the sum of all costs related to a product


or service during its life span.
Acquisition phase: Investment cost, capital investment,
working capital.
Operation phase: operation and maintenance cost,
disposal cost.

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Questions

If the capacity of an operation is significantly changed


(e.g., a manufacturing plant), the fixed costs will also
change. (T/F)
A nonrefundable cash outlay (e.g., money spent on a
passport) is an example of a sunk cost. (T/F)
Stock you own from a bankrupt and out-of-business
company is an example of a ... cost. (Choose one:
opportunity/sunk/direct/variable)

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Answers

If the capacity of an operation is significantly changed (e.g.,


a manufacturing plant), the fixed costs will also change. (T)
A nonrefundable cash outlay (e.g., money spent on a
passport) is an example of a sunk cost. (T)
Stock you own from a bankrupt and out-of-business
company is an example of a ... cost. (sunk)

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General economics concepts


Price-demand relationships
1

Model 1: Selling price per unit (p) is a linear function of


demand (D)
p = a bD for 0 D ab , and a > 0, b > 0
Model 2: Selling price per unit is independent of demand

Maximizing total revenue (TR): (Use Model 1)


TR = p.D = (a bD)D = aD bD2
TR is a concave function. (Check the second derivative:
d2 TR
= 2b < 0)
dD2
from the first derivative:
Find the maximizer D
dTR
a

dD = a 2bD = 0 D = 2b
Maximizing profit: (Use Model 1)
Profit = TR TC, what is Total Cost (TC)?
Assumption: TC = CF + cv D
where CF is the fixed cost and cv is the variable cost per
unit.
Thus, Profit = aD bD2 (CF + cv D)
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Maximizing profit contd

Maximizing profit:
Profit = aD bD2 (CF + cv D) = bD2 + (a cv )D CF
In order for a positive profit to occur and to avoid negative
demand, a cv > 0 or a > cv .
From the first derivative, we have
dProfit
acv

dD = a cv 2bD = 0 D = 2b .
2

Profit
Since d dD
= 2b < 0 for all D, D =
2
maximizer of the Profit.

acv
2b

is the

Remark: Companies may also gain insights from


Breakeven points other than the profit-maximizing points.
At a breakeven point, total revenue is equal to total cost.

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Breakeven analysis

Finding the breakeven points: (Model 1)


Solve bD2 + (a cv )D CF = 0. We obtain two roots:
D0 =

(acv )[(acv )2 4bCF ]1/2


2b

Finding the breakeven points: (Model 2)


p is independent of D.
TR = p.D
TC = CF + cv D
CF
TR = TC D0 = pc
(unique!)
v

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Example 2.2

A company produces circuit boards used to update outdated


computer equipment. The fixed cost is $42,000 per month, and
the variable cost is $53 per circuit board. The selling price per
unit is p = 150 0.02D. Maximum output of the plant is 4,000
units per month.
Determine the optimum demand that maximizes profit?
What is the maximum profit per month?
What is the breakeven point?
What is the companys range of profitable demand?

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Solution:
p = 150 0.02D, where a = 150 and b = 0.02; CF = 42, 000;
cv = 53.
v
a) D = ac
2b = 2, 425.
b) Profit = aD bD2 (CF + cv D) =
150(2, 425) 0.02(2, 425)2 (42, 000 + 53(2, 425)) = $75, 612.50.
2

1/2

4(0.02)(42,000)]
c) D0 = (15053)[(15053)
2(0.02)
D01 = 481; D02 = 4, 369.
d) D is profitable in the range 481 4, 369.

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Cost driven design optimization

The cost driven design optimization refers to how to design


the product in order to minimize the cost.
General approach:
1

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Identify the design variable that is the primary cost driver


(e.g., the thickness of the material).
Write an expression for the cost model in terms of the
design variable.
Find the optimum value of the design variable to have the
minimum cost value.

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Example 2.3

The cost of operating a large ship (CO ) varies as the square of


its velocity (v); specifically, CO = knv2 , where n is the trip length
in miles and k is a constant of proportionality. It is known that at
12 miles/hour the average cost of operation is $100 per mile.
The owner of the ship wants to minimize the cost of operation,
but it must be balanced against the cost of perishable cargo
(CC ), which the customer has set at $1,500 per hour. At what
velocity should the trip be planned to minimize the total cost
(CT ), which is the sum of the cost of operating the ship and the
cost of perishable cargo?

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Example 2.3

Solution:
We need to find k. Cost per mile is CnO = kv2 . At v = 12, cost per
100
mile is given as $100. Hence, k = (12)
2 = 0.694.
We want to minimize CT where CT = CO + CC = knv2 + 1, 500 nv
1,500 1/3
dCT
n

v = 10.25
dv = 0 2knv 1, 500 v2 = 0 v = ( 2k )
miles per hour.
(Note: Check the second derivative to verify CT is convex, i.e.,
d2 CT
> 0.)
dv2

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Present economy studies

When the time horizon over which projects and alternatives are
compared and evaluated is one year or less, and the influence
of the time on money can be ignored, these analyses are called
present economy studies.

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Example 2.4
Ocean water contains 0.8 ounce of gold per ton.
Method A:
costs $210 per ton of water processed and will recover
80% of the metal.
Method B:
costs $150 per ton of water processed and will recover
60% of the metal.
The two methods require the same investment and are capable
of producing the same amount of gold every day. If the
extracted gold can be sold for $380 per ounce. Assume that the
supply of ocean water is unlimited.
On the basis of profit per ounce of gold extracted, which
method of extraction should be used?

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Example 2.4
Solution:
Method A:
Profit per ounce =
$380 per ounce ($210 per ton of water)/(0.8 80%) =
$51.88.
Method B:
Profit per ounce =
$380 per ounce ($150 per ton of water)/(0.8 60%) =
$67.50.
Select Method B
Alternatively, since both methods have the same revenue, we
could also choose the method with the minimal cost.

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Example 2.5
Machine A and Machine B are being considered for the
production of a part of a product. The capital investment
associated with the machines are about the same and can be
ignored. The important differences between the machines are
their production capacities (product rate available
production hours);
their reject rates (% of parts produced that cannot be sold).

Production rate
Hours available for production
Reject rate

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Machine A
100 parts/hr
7 hrs/day
3%

Machine B
130 parts/hr
6 hrs/day
10 %

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Example 2.5

The material cost is $6.00 per part, and all defect-free parts
produced can be sold for $12 each. The rejected parts have no
value. For either machine, the operator cost is $15.00 per hour
and the variable overhead rate for traceable costs is $5.00 per
hour.
Assume that the daily demand for this part is large enough
that all defect-free parts can be sold. Which machine
should be selected?
What would be the reject rate have to be for Machine B to
be as profitable as Machine A?

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Example 2.5
Solution:
Since both machines have different total daily revenue and total
daily cost, we should base on the daily profit to select the
machine.
Profit per day
= Revenue per day Cost per day
= (Production rate)(Production hrs)($12/part)
(1 reject rate)
(Production rate)(Production hrs)($6/part)
(Production hrs)($15/hr + $5/hr)
Machine A: Profit per day = $3,808 per day.
Machine B: Profit per day = $3,624 per day.
Therefore, select Machine A.
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Example 2.5

The breakeven reject rate, X, for Machine B, can be obtained by


equating the profits from Machine A and Machine B.

3808 = (130)(6)(12)(1 X) (130)(6)(6) (6)(15 + 5)


X = 0.08.
So, the reject rate for Machine B can be no higher than 8% for it
to be as profitable as Machine A.

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