Cost Concepts and Design

Economics I

CE22 Lecture 2

MA. BRIDA LEA D. DIOLA

Institute of Civil Engineering
College of Engineering
University of the Philippines Diliman
Recall

¤ Engineering Economy

¤ Engineering Economic Decision

¤ 7 Principles of Engineering Economy

 7-step Engineering Economic Analysis
procedure
1. Problem recognition and evaluation.
2. Development of the feasible
alternatives.
3. Development of the cash flows for
each alternative.
4. Selection of a criterion ( or criteria).
5. Analysis and comparison of the
alternatives.
6. Selection of the preferred
alternative.
7. Performance monitoring and post-
evaluation results.
Discussion Topics

¤Cost estimating
¤Cost terminology
¤General economic environment
Cost vs Expenses

¤"Expense" is a specific cash or other

expenditure that can be followed
in the accounting system
¤"Cost" can refer to non-financial
matters, such as lost time,
aggravation, or pollution
 Cost Estimating

Cost Estimating

Used to describe the process by

which the present and future cost
consequences of engineering
designs are forecasted
 Cost Estimating

USES OF COST ESTIMATING

¤ Provide information used in setting a selling

price for quoting, bidding, or evaluating
contracts
¤ Determine whether a proposed product can
be made and distributed at a profit (EG: price
= cost + profit)
¤ Evaluate how much capital can be justified
for process changes or other improvements
¤ Establish benchmarks for productivity
improvement programs
 Cost Estimating

COST ESTIMATING APPROACHES

¤Top-down Approach
¤Bottom-up Approach
 Cost Estimating

TOP-DOWN APPROACH

¤ Uses historical data from similar engineering

projects
¤ Used to estimate costs, revenues, and other
parameters for current project
¤ Modifies original data for changes in
inflation / deflation, activity level, weight,
energy consumption, size, etc…
¤ Best use early in estimating process
 Cost Estimating

BOTTOM-UP APPROACH

¤Attempts to break down project into

small, manageable units and estimate
costs, etc….
¤Smaller unit costs added together with
other types of costs to obtain overall cost
estimate
¤Works best when detail concerning
desired output defined and clarified
 TOP-DOWN vs BOTTOM-UP

¤TOP-DOWN – target
costing

¤BOTTOM-UP – design to
price
Example

¤Forecast the expense of getting a

Bachelor of Science (B.S.) degree from
U.P. ( Four-year course)
¤Top-Down Approach
¤Bottom-Up Approach
TOP-DOWN APPROACH

¤Tuition fee/year + Other expenses/fees =

total estimated cost
¤Multiply by the number of years to finish
the course
BOTTOM-UP APPROACH

Total Cost of a B.S.

at UP

Year 1, 2, 3 and 4

Tuition and Other

Books and Supplies Living Expenses Transportation
Fees

Tuition, Activities Books, Duplication,

Rent, Food, Gas,
Fees, Supplies,
Clothing, Maintenance,
Memberships, Computer rental,
Recreation, Utilities Insurance, Fare
Medical, Lab fees Software
COST TERMINOLOGIES

https://residential.meralco.com.ph/billings-and-payment/business-centers/understanding-your-bill
 Activity
¤ The Paper Products Factory (PPF) is a local manufacturer of a single product:
paper party hats. They sell primarily to specialty stores in the Mid Atlantic
region of the United States. There are several other national and international
manufacturers of similar products; therefore it is a very competitive
marketplace. The market is very price sensitive; small increases in price can
result in large decreases in product demand.

¤ The PPF is a family owned company that employs approximately 100 people
as well as administrative staff including the president, vice presidents, and
support staff; engineers who design and develop the products; sales
representatives; manufacturing labor; distribution center employees; and
customer service representatives.

¤ The following raw materials are used in order to manufacture these products:
colored paper, staples, tape, and stickers. The following “manufacturing
equipment” is used in this factory simulation: stapler, tape dispenser, and
scissors.

¤ As a general manager, identify different cost elements involved in the

business.
 Cost Terminology

Cash Cost vs Book Cost

¤Cash cost is a cost that involves

payment in cash and results in cash flow.
¤Book cost or noncash cost is a payment
that does not involve cash transaction;
book costs represent the recovery of
past expenditures over a fixed period of
time. (e.g. depreciation)
¤ Included in the profit and loss accounts
and avail the tax advantages.
 Cost Terminology

Fixed vs Variable Costs

¤Fixed costs are those unaffected by

changes in activity level over a feasible
range of operations for the capacity or
capability available.
¤Variable costs are those associated with
an operation that vary in total with the
quantity of output or other measures of
activity level.
 Cost Terminology

INCREMENTAL COST

¤Incremental cost is the additional cost

that results from increasing the output of
a system by one (or more) units.
 Cost Terminology

Sunk Cost and Opportunity Cost

¤A sunk cost is one that has occurred in the

past and has no relevance to estimates of
future costs and revenues related to an
alternative course of action;
¤An opportunity cost is the cost of the best
rejected ( i.e., foregone ) opportunity and
is hidden or implied
¤Whenever a choice is made, something
is given up.
Example

¤ Suppose the heating, ventilating and air

conditioning (HVAC) system in your home has just
experienced a major failure. You immediately call
the Air Comfort Company for an estimate to
replace your system. Their price is $4,200 and you
gladly sign a contract and write a check for the
required $1,000 down payment. At this point the
weather warms and the urgency for replacement of
your defunct system eases somewhat. You then get
a second estimate for a new HVAC system. It is
$3,000. You call Air Comfort back and they inform
you that the $1,000 down payment is not
refundable! What should you do? Explain.
 Cost Terminology

Recurring vs Nonrecurring Costs

¤Recurring costs are repetitive and occur

when a firm produces similar goods and
services on a continuing basis. (i.e.
variable cost)
¤Nonrecurring costs are those that are not
repetitive, even though the total
expenditure may be cumulative over a
relatively short period of time;
 Cost Terminology

Direct vs Indirect Costs

¤Direct costs can be reasonably

measured and allocated to a specific
output or work activity (i.e. labor &
material)
¤Indirect costs are difficult to allocate to a
specific output or activity (cost of
general supplies, overhead costs)
 Cost Terminology

Life-Cycle Cost

Life-cycle cost is the summation of all costs, both

recurring and nonrecurring, 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.
Lifecycle Cost: Example

Source: MIT Opencouseware Project evaluation notes

 Cost Terminology

Capital and Investment

¤ Investment Cost or capital investment is the capital

(money) required for most activities of the
acquisition phase;
¤ Working Capital refers to the funds required for
current assets needed for start-up and subsequent
support of operation activities;
¤ Operation and Maintenance Cost includes many of
the recurring annual expense items associated with
the operation phase of the life cycle;

¤ Disposal Cost includes non-recurring costs of

shutting down the operation;