Chapter 2

Cost Concepts And Design

Economic

Created By : Eng. Saad Hamasha

& Eng.Maysaa Gharaybeh
Fixed, Variable and Incremental
costs.
Fixed costs :

 Unaffected by changes in activity level over a

feasible range of operations for the capacity or
capability available.

 Example :insurance and taxes on facilities,

administrative salaries, license fees, and
interest costs on borrowed capital.
Variable Costs :

• It vary in total with the number of the output

unite .
• Example :
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.
 More ways to categorize costs

• Direct: can be measured and allocated to a specific

work activity
(Materials, Labor)
• Indirect: difficult to attribute or allocate to a
specific output or work activity
(overhead, maintenance)
• Standard cost: cost per unit of output,
Standard costs play an important role in cost control and
other management functions.
• 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.
( equipments, machines, Depreciation)

• 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.
(money spend on a passport)
• Opportunity cost: the monetary advantage foregone due
to limited resources. The cost of the best rejected
opportunity.
( A student can work with 10,000$ Per year.
or goes to the university for a year and spend 5,000$.
Opportunity cost = 15,000$)

• Life-cycle cost: the summation of all costs related to a

product, structure, system, or service during its life
span.
Example 2-1
Cost Factor Site A Site B •5,000 cubic yards of
Distance 6 miles 4.3 miles asphalt
Monthly rental $1,000 $5,000 •4 months (17 weeks
cost 5- days a week)
Cost (Set up $ $15,000 $25,000 •Compare the
Removing)
Equipment
2 sites??!!!!!
Hauling $1.15/yd3 – $1.15/yd3 – •NOTE:
expenses mile mile •Rent , Set up/
Removal and Flag
Flag person No need $96/day person are Fixed costs
($8,160) BUT
BUT Hauling is variable cost
Site A = 6*5000*$1.15 = $345,000
Site B= 4.3*5,000*$1.15 = $247,250
Then the total cost is
2. Which is the better site? Site B

3. How many cubic yards of asphalt does the contractor have to

deliver before starting to make a profit if paid 8.05$ per cubic yard
The General Economic Environment
Consumer and Producer Goods and Service

Consumer Goods and Service: are those

products or service that are directly used by
people to satisfy their wants.

Producer Goods and Service: are used to

produce consumer goods or service or other
producers goods.
Goods and service are produced and desired because they
have utility.

Utility: The power to satisfy human wants and needs.

Utility is most commonly measured in terms of value.

Value: the price that must be paid to obtain the particular

item.

Necessities and Luxuries needs.

 Price And Demand
 Engineering focusing on increasing the utility
(value) of materials by changing their form or
location.

 P : the price that must be paid

 D: is the quantity that must 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
for 0 ≤ D ≤ a/b , a > 0, b > 0

where p is price, D is demand, and a and b are constants

that depend on the particular product or service.
a = price axis intercept
-b = slope
 Competition

Perfect Competition: occurs in a situation in which any

given product is supplied by a large number of venders and
there is no restriction on additional suppliers entering the
market (never occurs in actual practice).

Perfect Monopoly: exist when a unique product or service is

only available from a single supplier and that vender can
prevent the entry of all others into the markets.
(rarely occurs in the practice)
 Total Revenue Function

Total revenue is the product of the selling price per unit,

p, and the number of units sold, D.
TR = p × D

From: p = a – bD

We find:
 Maximize Revenue

TR  a D  b D 2

d 2TR
2
  2b  0
dD

ˆ a
The demand at maximum revenue: D
2b
2 2 2
a a a
Maximum TR  a Dˆ  b Dˆ 2   
2b 4b 4b
 Profit

Profit = Total Revenue (TR) – Total Cost (CT)

Total Cost (CT) = Fixed Cost (CF) + Variable Cost (CV)

CT  C F  CV

Variable Cost (CV) = Variable cost per unit (cv) × Demand (D)
CV  cv  D

Total Cost: CT  C F  cv D
 Maximum profit

Scenario 1: Demand is a function of price ( p = a – bD)

TR  a D  b D 2
 Profit = Total Revenue (TR) – Total Cost (CT)

and CT  CF  cv D

and TR  a D  b D 2

Then Profit  (a D  b D 2 )  ( CF  cv D)
Profit   b D 2  (a  cv ) D  CF

To find the maximum profit d ( profit )

 a  cv  2 b D  0
dD
d 2 ( profit )
2
  2b  0
dD

a  cv
Demand at Max profit: D *
2b
Breakeven points are found when
Total Revenue = Total Cost.

a D  b D 2  CF  cv D
 b D 2  (a  cv ) D  CF  0

The demand at breakeven:

D 
 2

 a  cv   a  cv   4  b  C F 
1
2

 2b
Example: A company produces an electronic timing switch. The fixed
cost (CF) is 73,000$ per month. The variable cost per unit (cv) is
83$. The selling price per unit (p = 180$ – 0.02D).
A. Determine the optimal volume of product?
B. Find the volume at breakeven occurs, what is the range of
profitable demand?

Solution:
A. a = 180, b = 0.02
a  cv 180  83
D *   2,425 units per month
2b 2  0.02
B. Total Revenue = Total Cost.
a D  b D 2  CF  cv D
 b D 2  (a  cv ) D  CF  0

D 
 2

 a  cv   a  cv   4  b  C F 
1
2

 2b

D 

 97  97   4  0.02 73000
2

1
2

 20.02

 97  59.74
D1   932 unit per month
 0.04
 97  59.74
D2   3,918 unit per month
 0.04
Range = 932 to 3,918 unit per month
Scenario 2: Price and Demand are independent

TR = P × D
Example:
Variable cost per service hour = 62$.
Selling price = 85.56$ per hour.
Maximum Hours per year = 160,000 hours.
Fixed cost = 2,024,000$ per year.
A. What is the breakeven point in hours and in % of total capacity?

Total revenue = Total cost (breakeven)

p D  CF  cv D
CF
D 
 p  cv 
2024000
D   85,908 hours per year
85.56  62
85,908
D   0.537  53.7% of capacity
160,000
B. What is the % reduction In breakeven point (sensitivity) if:
1. Fixed cost reduced by 10%?

0.92024000
D   77,138 hours per year
85.56  62
85,908  77,318
D reduction   0.1 10%
85,908

2. variable cost per hour reduced by 10%?

2024000
D   68,011 hours per year
85.56  0.9  62
85,908  68.011
D reduction   0.208  20.8%
85,908
3. selling price increase by 10%?

2024000
D   63,021 hours per year
1.1 85.56  62
85,908  63,021
D reduction   0.266  26.6%
85,908

Then the breakeven point is more sensitive to reduction in

variable cost than fixed cost