LECTURE 1

Cost Analysis and Engineering Economy

Course overview
Week Topic
1 Cost concepts and estimation
2 Time value of money
3 Interest rates and project returns
4 Inflation and foreign exchange
5 Review lecture
6 Depreciation and taxes
7 Equipment replacement analysis
8 Review lecture
9 Risk and uncertainty
Self-Directed Learning
10 Capital budgeting Zoom Lecture
11 Review lecture
Project
• Topic can be anything that is related to economic decision
making.

• It could be a business decision:

• Should an online retail store manage their own delivery service or
outsource?

• It could be personal decision making:

• Is it economically wise to pursue a Master degree?
Project
• The project should contain, but is not limited, to the following
components:

• Problem description (what is the problem, why is it interesting)

• Data description (what are the cost data used in your analysis, how are they
obtained/estimated)

• Analysis (what is the best decision, how good is this decision)

• Recommendations and discussion (what are your recommendations, are there

any interesting insights or generalizations that you can draw)

• Deliverables: Report (max 20 pages), Presentation (max 10 min)

• Group size: 5 ± 1 => form groups by 8 Feb 2021

Outline
• Cost concepts • Cost estimation
• Fixed and variable cost • Index technique
• Opportunity cost • Unit technique
• Sunk cost • Power sizing technique
• Cash and book cost • Factor technique
• Incremental cost • Multivariate regression
• Learning and improvement
• Price setting
• Breakeven
• Profit-maximizing
• Price discrimination
Fixed and variable costs
• Fixed costs
• Unaffected by changes in activity level over a feasible range of
operations for the capacity or capability available.
• Examples include facility insurance and management salary.
• However, fixed costs may vary with large changes in usage of
resources.

• Variable costs
• Varies with the quantity of output.
• Material cost is an example of variable cost.
Fixed price analysis
• Total cost is generally expressed as:

Total cost = Total fixed cost + Demand × Variable cost

• Total revenue is generally expressed as:

Total revenue = Demand × Price

• Profit is the difference between total revenue and total cost:

Profit = Total revenue − Total cost

Breakeven volume
• As a result of fixed costs, there is usually a minimum number of units
for production to be economically justifiable.

• Breakeven volume: The minimum quantity where total revenue is no

lesser than total cost.

• Suppose you plan to open a store that sells coffee. Monthly rental and
labor cost are $10,000 and $8,000, respectively. Material cost is
$0.30 per cup. What is the breakeven volume if a cup of coffee is
priced at $1.50?

1.5𝐷𝐷 ≥ 10,000 + 8,000 + 0.3𝐷𝐷

𝐷𝐷 ≥ 15,000

• Breakeven volume is 15,000 cups per month or 500 cups per day.
Price-demand curve
• In general, demand decreases with selling price.
• However, profit per unit increases with selling price.

120

100

80 profit per unit

60

40

20
demand
0
0 5 10
selling 15
price 20 25 30

• Breakeven price: Price at which profit is (approximately) zero.

• Profit maximizing price: Price at which profit is maximal.
Example: Electronic timing switch
A company produces an electronic timing switch that is used in consumer
and commercial products. The fixed cost is $73,000 per month and the
variable cost is $83 per unit. The selling price 𝑝𝑝 and demand 𝐷𝐷 are related
by the following equation: 𝑝𝑝 = $180 − $0.02𝐷𝐷.

Profit = 180 − 0.02𝐷𝐷 𝐷𝐷 − 73,000 + 83𝐷𝐷 = −0.02𝐷𝐷2 + 97𝐷𝐷 − 73,000

Setting profit to be no less than $0, we get:

932 ≤ 𝐷𝐷 ≤ 3,918

and the corresponding range of prices:

min price = $180 − $0.02 × 3,918 = $101.64

max price = $180 − $0.02 × 932 = $161.36

Example: Electronic timing switch
A company produces an electronic timing switch that is used in consumer
and commercial products. The fixed cost is $73,000 per month and the
variable cost is $83 per unit. The selling price 𝑝𝑝 and demand 𝐷𝐷 are related
by the following equation: 𝑝𝑝 = $180 − $0.02𝐷𝐷.

Profit = 180 − 0.02𝐷𝐷 𝐷𝐷 − 73,000 + 83𝐷𝐷 = −0.02𝐷𝐷2 + 97𝐷𝐷 − 73,000

Differentiating with respect to demand:

−0.04𝐷𝐷 + 97 = 0

which implies the optimal demand D∗ = 2,425 and the profit maximizing
price is:

$180 − $0.02 × 2,425 = $131.50

Discount coupons
• Why does McDonald’s offer discount coupons?
Price discrimination
• In the previous worked examples, we assumed that the
selling price is constant across all buyers.

• However, different buyers are willing to pay different

prices for a product/service.

• Sellers can increase profits by charging different prices for

the same product/service (e.g., Macdonald’s).

• This is commonly referred to as price discrimination.

Example: Discount coupon
• Ann runs a spa and charges her customers $100 per visit.

• At that price, she gets 200 customers each month.

• She believes that if the price was $60, she will get 350
customers.

• Suppose the variable cost of serving each customer is $10.

• It costs her $1,000 each month to print the discount coupons.

• Which strategy maximizes her profits:

• Charge $100
• Charge $60
• Charge $100 and print 40% discount coupons
Example: Discount coupon
• If she charges $100 per visit: Decision making
under uncertainty
Profit = 200 × 100 − 10 = 18,000 will be discussed
in Week 9
• If she charges $60 per visit:

Profit = 350 × 60 − 10 = 17,500

The decision can
• If she charges $100 per visit and prints discount coupons: be fairly clear
even though 𝑁𝑁 is
Profit = 350 × 100 − 10 − 𝑁𝑁 × 40 − 1000 uncertain.

• Printing coupons increases profits when:

350 × 100 − 10 − 𝑁𝑁 × 40 − 1000 > 18,000 ⇒ 𝑁𝑁 < 312.5

• We should print coupons if less than 312 of the 350 (89.1%) customers use
coupons.
Opportunity cost
• Opportunity cost is opportunity forfeited as a result of your decision.

• Suppose that it cost $350M and 3 years to build a condominium,

which can be sold for $400M.

• Profit of undertaking this project is $400M – $350M = $50M.

• If $350M was left in the bank for 3 years at 5% per annum, interest
earned is:

($350M × 1.05 × 1.05 × 1.05) − $350M = $55.2M

• Hence, opportunity cost of undertaking this project, rather than

depositing that amount of money with a bank for 3 years, is $55.2M.

• In the scenario above, will you undertake this project?

Property development in Singapore
• In Singapore, developers may start to sell apartments before they are
completed (see: Housing Developer License).

• The ability to use sales proceeds to fund the construction reduces the
opportunity cost of the project.

• However, URA may not award a

Sales License in certain cases:
• Kingsford Huray Case
• 30 Dec 2020 Update

• In practice, buyers pay for their condominium purchase in stages

(see: Progressive Payment Scheme).
Economic decision making
• The previous example highlights the importance of taking
into account opportunity cost in economic decision
making.

• In general, money today is more valuable then money in

the future. This concept of time value of money will be
covered in Week 2.

• The economic evaluation of investments will be covered

in Week 3.

• Related concepts, including inflation and foreign

exchange will be covered in Week 4.
Sunk cost
• Sunk cost is cost that has already been incurred and has no relevance to
future cost and/or revenue.

• Sunk cost should not be considered in economic decision making.

• Suppose you are interested in purchasing an apartment that is priced at

$800,000. You paid a booking fee of $40,000 for an option to purchase the
apartment at this price. When you apply for your housing loan, the bank
informs you that their valuation of the apartment is $750,000. Should you
exercise your option to purchase the apartment?

• The inability to ignore sunk cost causes people to hold on to poor performing
stocks instead of cutting losses.
Cash and book cost
• Cash cost
• Involves the payment of cash.
• Examples include labor and material cost.
Purchase: $100,000
Value (1 year): $85,000
• Book cost Sold (1 year): $87,000
• Does not involve the transfer of cash.
• Computed based on estimated value of asset.
• Depreciation is a book cost that is commonly encountered in
practice.

• Depreciation will be covered in Week 6.

 Incremental cost
Incremental cost analysis will be
discussed further
in Week 7.
• Incremental costs
• Additional cost that results from increasing output by one (or more) units.
• Useful for profit maximization and average cost minimization.

• Suppose:
• Milk powder are priced at $30 each on an online store.
• Delivery charges are $5 (1 to 3 cans) and $10 (4 to 6 cans)
• The incremental cost of ordering 3 rather than 2 cans of milk:

• The incremental cost of ordering 4 rather than 3 cans of milk:

Cost estimation
• Cost data are required for an economic analysis of choices
available to the decision maker.

• Cost data is often estimated in practice:

• Cost data is unavailable
• Cost structure is too complicated

• Cost estimation approaches

• Index technique
• Unit technique
• Factor technique
• Power sizing technique
• Multivariate regression
• Learning and improvement
Index technique
• Used to account for annual price changes.

𝐼𝐼𝑛𝑛
𝐶𝐶𝑛𝑛 = 𝐶𝐶𝑘𝑘
𝐼𝐼𝑘𝑘

𝐶𝐶𝑛𝑛 : estimated cost of item in year 𝑛𝑛

𝐶𝐶𝑘𝑘 : cost of item in year 𝑘𝑘
𝐼𝐼𝑛𝑛 : index value in year 𝑛𝑛
𝐼𝐼𝑘𝑘 : index value in year 𝑘𝑘

• Common indices:
• CPI: Consumer price index
• PPI: Producer price index (see example)
Example: Index or ratio technique
• In 2011, it costs $750,000 to build a 50,000 lbs/hr boiler.
• The PPI at 2011 is 148.3.
• The index is currently 160.3.

• The estimated cost of building a similar boiler now:

160.3
$750,000 × = $810,688
148.3
Unit technique
12
• Used to account for
different sizes or 10

quantities.
8

Cost = size × unit cost

cost
6

• It assumes that price 4

varies linearly with

size or quantity. 2

0
0 2 4
size
6 8 10 12
Example: Unit technique
• A 1,000 sq-ft apartment is priced at $1.5M.
• Estimate the price of a 500 sq-ft apartment in the same development.

• Unit price:

$1,500,000
= $1,500 per sq−ft
1000

• Estimated price of 500 sq-ft apartment:

500 × $1,500 = $750,000

• In reality, a 500 sq-ft apartment is priced significantly higher than

$750,000.

• What is the reason for this discrepancy?

Power sizing technique
• Also used to account for different sizes or quantities.
• Generalizes the unit technique.

X
𝑆𝑆𝐴𝐴
𝐶𝐶𝐴𝐴 = 𝐶𝐶𝐵𝐵
𝑆𝑆𝐵𝐵

𝐶𝐶𝐴𝐴 : cost of plant A

𝐶𝐶𝐵𝐵 : cost of plant B
𝑆𝑆𝐴𝐴 : size of plant A
𝑆𝑆𝐵𝐵 : size of plant B
𝑋𝑋: cost capacity factor
Power sizing technique
• The cost capacity factor reflects economies of scale:

𝑋𝑋 < 1: marginal cost decreases with size

𝑋𝑋 = 1: constant marginal cost (unit technique)

𝑋𝑋 > 1: marginal cost increases with size

• The cost capacity factor for nuclear generating plants and

fossil-fuel generating plants are 0.68 and 0.79, respectively.

• Do the values above make sense?

Example: Power sizing technique
• A 200-MW fossil-fuel plant costs $300M. What is the cost
of building a 600-MW fossil-fuel plant now? The cost
capacity factor for fossil fuel plants is 0.79.

• Cost of 600-MW plant:

0.79
600
$300M = $714M
200
Factor technique
• The unit technique can be extended to handle multiple
cost components.

• Estimate the cost of building a 2,000 sq-ft house with two

porches and a garage, where general construction cost is
$85 per sq-ft, cost of a porch and garage are $10,000 and
$8,000, respectively:

2,000 × $85 + 2 × $10,000 + $8,000 = $198,000

Multivariate regression
• The factor technique assumes that the unit cost of each
cost component is known.

• However, that may not be true in practice.

• Under this situation, one can use multivariate regression

to obtain cost estimates if cost data of similar units are
available.
Multivariate regression
• Suppose there are 𝑛𝑛 parameters of interest.
• Linear model:

𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 = 𝑏𝑏0 + 𝑏𝑏1 𝑥𝑥1 + 𝑏𝑏2 𝑥𝑥2 + ⋯ + 𝑏𝑏𝑛𝑛 𝑥𝑥𝑛𝑛

𝑏𝑏𝑖𝑖 : coefficient associated with parameter 𝑖𝑖

𝑥𝑥𝑖𝑖 : value of parameter 𝑖𝑖

• R-squared value (between 0 and 1): describes how well

the model fits the data.
Example: Multivariate regression
Estimate the cost of building a 2,000 sq-ft house with two
porches and a garage given the following 7 cost data:

Size/sq-ft # Porch # Garage Cost/$

1,500 1 0 $135,000
1,700 0 1 $150,000
1,850 1 1 $170,000
2,125 2 0 $230,000
2,200 1 1 $240,000
3,200 1 1 $300,000
5,600 2 2 $480,000
Example: Multivariate regression

Cost = $21,506 + $71 × size + $24,944 × # porch + $10,548 × # garage

Example: Multivariate regression
• Regression model:

Cost = $21,506 + $71 × size + $24,944 × # porch + $10,548 × # garage

• Therefore, the estimated cost of building a 2,000 sq-ft

house with two porches and a garage is:

$21,506 + $71 × 2,000 + $24,944 × 2 + $10,548 = $223,942

Learning and improvement
• Accounts for increased worker efficiency and improved organizational
performance with repetitive production of a good or service.

• This was first observed in the aircraft and aerospace industry with
respect to labor hours per unit.

𝑍𝑍𝑢𝑢 = 𝑍𝑍1 𝑢𝑢𝑛𝑛

𝑢𝑢: output unit number

𝑍𝑍𝑢𝑢 : number of input resources to produce output unit 𝑢𝑢
𝑛𝑛: learning curve exponent (𝑛𝑛 ≤ 0)

• Pace of learning increases as learning curve exponent 𝑛𝑛

decreases.
Example: Learning and improvement
• A local start-up recently launch a new product.
• It took 2,000 man-hours to build the first unit and 1,600 man-hours to
build the second unit.
• Estimate the number of man-hours it takes to build the eighth unit.

𝑍𝑍2 = 𝑍𝑍1 2𝑛𝑛

1600
= 2𝑛𝑛
2000
ln 0.8 = ln 2𝑛𝑛
ln 0.8 = 𝑛𝑛 ln 2
𝑛𝑛 = −0.322

• Hence, 𝑍𝑍8 = 2000 8 −0.322 = 1024 man−hours

Learning and improvement
• It is useful to define the learning slope parameter 𝑠𝑠:

𝑠𝑠 = 𝑒𝑒 𝑛𝑛 ln 2

ln 0.9
• Suppose 𝑛𝑛 = = −0.152:
ln(2)

𝑠𝑠 = 𝑒𝑒 −0.152×ln 2 = 0.9

• Suppose 1st unit took 100 man-hours:

𝑍𝑍2 = 100 × 2−0.152 = 90 man−hours

𝑍𝑍4 = 100 × 4−0.152 = 81 man−hours

𝑍𝑍8 = 100 × 8−0.152 = 72.9 man−hours

Learning and improvement
• It is useful to define the learning 1.2
slope parameter 𝑠𝑠:

𝑠𝑠 = 𝑒𝑒 𝑛𝑛 ln 2 1

• Suppose 𝑠𝑠 = 0.9 0.8

• 100 man-hours for 1st unit
• 90 man-hours for 2nd unit
𝑠𝑠=0.9

resource
• 81 man-hours for 4th unit
0.6
• 72.9 man-hours for 8th unit

• 1 − 𝑠𝑠 represents the reduction in 0.4

resources required for every 𝑠𝑠=0.75
doubling of units produced.
0.2
• Therefore:
𝑠𝑠 = 0.5
0
𝑍𝑍2 0 5 10
𝑠𝑠 = units15produced
20 25 30 35
𝑍𝑍1
Example: Learning and improvement
• A local start-up recently launch a new product.
• It took 2,000 man-hours to build the first unit and 1,600 man-hours to
build the second unit.
• Estimate the number of man-hours it takes to build the eighth unit.

1600
𝑠𝑠 = = 0.8
2000

𝑍𝑍8 = 2000 × 0.8 × 0.8 × 0.8 = 1,024 man−hours

Cost estimation
• Index technique (account for price changes)

• Unit technique (different size, linear)

• Power sizing technique (different size, general)

• Factor technique (different size and components)

• Multivariate regression (estimate unit costs)

• Learning and improvement (estimate man-hours)

Homework 1
Self-Directed Learning