Module 2: Cost Concepts and Design

Economics
 Chapter Objectives

At the end of this chapter, you will be able to:

• Discuss the fundamental of cost concepts & terminology

• Apply cost concept in design decision

• Analyze short-term alternatives when the time value of

money is not a factor

2
 Case Study – UTP

• Established in 1996 (23 yrs ago) as a private higher

education offering engineering and technology
programs.

• The campus was built on a 400 hectares land

formerly the site of USM Engineering Campus at an
estimated costs of RM250 million.

• The academic complex was planned and built at an

estimated costs of RM 1.5 billion.

• The annual operating expenditure (a larger chunk of

it is for emolument) is estimated at RM 300 million.

• The company revenue (from tuition fee collected) is

estimated at RM 150 million and the shortfall is
subsidized by PETRONAS corporate donation to
YUTP.
 Costs

Costs can be categorized in several different ways.

 Fixed cost: unaffected by changes in activity level
 Variable cost: vary in total with the quantity of
output (or similar measure of activity)
 Incremental cost: additional cost resulting from
increasing output of a system by one (or more) units

 Direct: can be measured and allocated to a specific work activity

 Indirect: difficult to attribute or allocate to a specific output or
work activity (also overhead or burden)
 Standard cost: cost per unit of output, established in advance of
production or service delivery
 Example 1 – Costs

Road resurfacing project: asphalt mixing sites

Project require 50,000 cubic yards @ $12.00/cubic yard for 4 months (17 weeks of 5 working days)

Site B has higher capital expenditure but

has lower overall costs. Cost recovered
after 24,200 cubic yards delivered.
5
 Costs Terminologies

Common terminologies for costs

 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

 Opportunity cost: the monetary advantage foregone due to limited

resources. The cost of the best rejected opportunity.
 Life-cycle cost: the summation of all costs related to a product,
structure, system, or service during its life span.
 Lifecycle Costs
Total costs of product, structure, systems and services for the entire life of
project

7
 Life Cycle Cost Analysis
 When comparing different design alternatives, we need to consider both non-
recurring as well as recurring costs over the life span of each design
alternative.
 Select alternative that fulfill the same performance requirements, but differ
with respect to initial and operating costs
 Example 2 – Pumping System

Pumping System with a Problem Valve

❑ Decision Problem: Fixing a pumping

system with a faulty valve.
❑ Design options:
o Option A: Buy a new control valve.

o Option B: Trim the pump impeller

to reduce the pressure.
o Option C: Install a variable-
frequency drive (VFD).
o Option D: Repair the valve as
needed.

9
 Example 2 – Pumping System
Cost comparison for all design options

10
 Example 2 – Pumping System
Life Cycle Cost comparison for all design options

𝒅−𝒊
𝒓=
𝟏+𝒊

11
 Example 2 – Pumping System

Option A 2 3 4 5 6 2 3 4 5 6
1 7 8 1 7 8

=
91,827
A
𝐴 = 91,827(𝐴Τ𝑃, 8%, 8) = 91,827 × 0.1740 = $15,979

$15,979
𝐶𝑜𝑠𝑡 𝑝𝑒𝑟 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 ℎ𝑜𝑢𝑟 = = $2.66
6,000

𝑂𝑝𝑡𝑖𝑜𝑛 𝐵 = (59,731 × 0.1740)/6,000 = $1.73

𝑂𝑝𝑡𝑖𝑜𝑛 𝐶 = (74,313 × 0.1740)/6,000 = $2.16
𝑂𝑝𝑡𝑖𝑜𝑛 𝐷 = (113,930 × 0.1740)/6,000 = $3.30

12
 Principle of Economy

Price – Demand Curve

The demand for a product or service is directly related to its price

p = a – bD

P – price D – demand S - supply

13
 Minimum Cost Analysis
 Total cost is given in terms of a specific design parameter.
 Find the optimal design parameter that will minimize the total cost.

c
AE(i) = a + bx +
x Total Cost

Capital Cost
Cost ($)

O&M Cost

Design Parameter (x) c

x =
*

b
Optimal Value (x*)
14
 Price-Demand

𝑝 = 𝑎 − 𝑏𝐷

𝑎
𝑓𝑜𝑟 0 ≤ 𝐷 ≤, 𝑎𝑛𝑑 𝑎 > 0, 𝑏>0
𝑏
𝑎−𝑝
𝐷= (𝑏 ≠ 0)
𝑏

15
 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 (eq. 2-4).

𝑇𝑅 = 𝑝𝐷 𝑏𝑢𝑡 𝑝 = 𝑎 − 𝑏𝐷

𝑇𝑅 = 𝑎 − 𝑏𝐷 𝐷
𝑇𝑅 = 𝑎𝐷 − 𝑏𝐷2
𝑎
𝑓𝑜𝑟 0 ≤ 𝐷 ≤ 𝑎𝑛𝑑 𝑎 > 0, 𝑏>0
𝑏

16
 Maximizing Total Revenue

𝑇𝑅 = 𝑎𝐷 − 𝑏𝐷2

2 2 2
𝑎 𝑎 𝑎
෡ − 𝑏𝐷
𝑀𝑎𝑥𝑖𝑚𝑢𝑚 𝑇𝑅 = 𝑎𝐷 ෡2 = − =
2𝑏 4𝑏 4𝑏

17
 Profit Function

Profitable venture require higher revenue and lower costs

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝐶𝑜𝑠𝑡

Total costs consists of fixed cost and variable cost

𝐶𝑇 = 𝐶𝐹 + 𝐶𝑉 Where: CT is total cost

CF is fixed cost
CV is variable cost
𝐶𝑉 = 𝑐𝑣 × 𝐷 cv is variable cost per unit

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑎𝐷 − 𝑏𝐷2 − (𝐶𝐹 + 𝑐𝑣 𝐷)

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑎𝐷 − 𝑏𝐷2 − 𝐶𝐹 − 𝑐𝑣 𝐷)
𝑃𝑟𝑜𝑓𝑖𝑡 = −𝑏𝐷2 + 𝑎 − 𝑐𝑣 𝐷 − 𝐶𝐹

18
 Maximizing Profit

𝑃𝑟𝑜𝑓𝑖𝑡 = −𝑏𝐷2 + 𝑎 − 𝑐𝑣 𝐷 − 𝐶𝐹
𝑑𝑃𝑟𝑜𝑓𝑖𝑡
= −2𝑏𝐷 + 𝑎 − 𝑐𝑣 = 0
𝑑𝐷
𝑎 − 𝑐𝑣
𝐷∗ =
2𝑏

𝑃𝑟𝑜𝑓𝑖𝑡 = −𝑏𝐷2 + 𝑎 − 𝑐𝑣 𝐷 − 𝐶𝐹
𝑑𝑃𝑟𝑜𝑓𝑖𝑡
= −2𝑏𝐷 + 𝑎 − 𝑐𝑣
𝑑𝐷
𝑑 2 𝑃𝑟𝑜𝑓𝑖𝑡
= −2𝑏
𝑑2𝐷
 Breakeven Point

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡

𝑎𝐷 − 𝑏𝐷2 = 𝐶𝐹 + 𝑐𝑣 𝐷

−𝑏𝐷2 + 𝑎 − 𝑐𝑣 𝐷 − 𝐶𝐹 = 0

− 𝑎 − 𝑐𝑣 ± 𝑎 − 𝑐𝑣 2 − 4(−𝑏)(−𝐶𝐹 )
𝐷′ =
2(−𝑏)
 A380 Superjumbo’s Breakeven Point
21
When Europe’s Airbus Company approved the A380 program in 2000, it was
estimated that only 250 of the giant, 555-seat aircraft needed to be sold to
break even. The program was initially based on expected deliveries of 751
aircraft over its life cycle. Long delays and mounting costs, however, have
dramatically changed the original breakeven figure. In 2005, this figure was
updated to 270 aircraft. According to an article in the Financial Times
(October 20, 2006, p. 18), Airbus would have to sell 420 aircraft to break
even— a 68% increase over the original estimate. To date, only 262 firm
orders for the aircraft have been received.
 A380 Superjumbo’s Breakeven Point
22

Scenario 2 When the price per unit

(p) for a product or service can be
represented more simply as being
independent of demand [versus
being a linear function of demand,
as assumed in Equation (2-1)] and
is greater than the variable cost per
unit (cv), a single breakeven point
results. Then, under the assumption
that demand is immediately met,
total revenue (TR) = p · D. If the
linear relationship for costs in
Equations (2-7) and (2-8) is also
used in the model, the typical
situation is depicted in Figure 2-6.
This scenario is typified by the
Airbus example.
 Example 3 – Costs-Volume Analysis

 Profit Maximization for a Short-Run Period

❑ Profit function
❑ Total revenue (TR) and total cost (TC) Functions

❑ Profit Function

❑ Optimum activity level

23
Contribution Margin and Break-Even Sales

❑ Profit Function

❑ Break-Even Volume (units)

marginal contribution

❑ Break-Even Sales ($)

marginal contribution rate

 Exercise 1 – Demand Estimation

Acme Manufacturing is a major player in the lawn sprinkler business.

Their high-end sprinkler is used commercially, and is quite popular with
golf course greens keepers.

In producing these sprinklers Acme’s fixed cost (CF) is $55,000 per

month with a variable cost (cv) of $15.50 per unit.
The selling price for these high-end sprinklers is described by the
equation p=$87.50 – 0.02(D).

a) What is the optimal volume of sprinklers?

Does Acme make a profit at that volume?
b) What is the range of profitable demand?
 Exercise 1 – Profit Estimation
(a) What is the optimal volume of sprinklers? Does Acme make a profit at that volume?

𝐶𝐹 = $55,000 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ 𝑐𝑣 = $15.50 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 𝐶𝑇 = 𝐶𝐹 + 𝑐𝑉 𝐷 = $55,000 + $15.50D

𝑝 = 87.50 − 0.02𝐷 𝑎 = 87.50 𝑎𝑛𝑑 𝑏 = 0.02
𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑝𝐷 = 87.50 − 0.02𝐷 𝐷 = −0.02𝐷2 + 87.50𝐷
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = −0.02𝐷2 + 87.50𝐷 − (55,000 + 15.50𝐷)
𝑃𝑟𝑜𝑓𝑖𝑡 = −0.02𝐷2 + 72𝐷 − 55,000
𝑑𝑃𝑟𝑜𝑓𝑖𝑡
= −0.04𝐷 + 72 = 0 𝐷 = 1,800 𝑢𝑛𝑖𝑡𝑠
𝑑𝐷
𝑃𝑟𝑜𝑓𝑖𝑡 = −0.02 1,800 2 + 72 1,800 − 55,000 = $9,800

𝑎 − 𝑐𝑣 87.50 − 15.50
𝑂𝑟 𝐷∗ = = = 1,800
2𝑏 2(0.02)

𝑃𝑟𝑜𝑓𝑖𝑡 = −𝑏𝐷2 + 𝑎 − 𝑐𝑣 − 𝐶𝐹 = − 0.02 1,800 2 − 55,000 = $9,800

 Exercise 1 – Profit Estimation
(b) What is the range of profitable demand?

𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑎𝐷 − 𝑏𝐷2 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝐶𝐹 + 𝑐𝑣 𝐷

𝐵𝑟𝑒𝑎𝑘𝑒𝑣𝑒𝑛; 𝑤ℎ𝑒𝑛 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡

𝑎𝐷 − 𝑏𝐷2 = 𝐶𝐹 + 𝑐𝑣 𝐷 𝐶𝐹 = $55,000 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ
−𝑏𝐷2 + 𝑎 − 𝑐𝑣 𝐷 − 𝐶𝐹 = 0 𝑐𝑣 = $15.50 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝑎 = 87.50 𝑎𝑛𝑑 𝑏 = 0.02

−0.02𝐷2 + 87.50 − 15.50 𝐷 − 55,000 = 0
−0.02𝐷2 + 72𝐷 − 55,000 = 0

−72 ± 722 − 4(−0.02)(−55,000)

𝐷′ = = 1,100 𝑜𝑟 2,500
2(−0.02)

−𝑏 ± 𝑏2 − 4𝑎𝑐
𝑥′ =
2𝑎
 Cost-Driven Design Optimization

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.

 Design for the Environment (DFE), or “green engineering for

environmental and social consequences over the life of their designs.

 Engineering design is an economically driven art.

 Cost-Driven Design Optimization

Two main tasks are involved in cost-driven design optimization.

1. Determine the optimal value for a certain alternative’s design variable. For
example, what velocity of an aircraft minimizes the total annual costs of
owning and operating the aircraft?

2. Select the best alternative, each with its own unique value for the design
variable. For example, what insulation thickness is best for a home in
Virginia: R11, R19, R30, or R38?

Cost models are developed around the design variable, X.

 Cost Model

Here is a simplified cost model.

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.
 Design Optimization

Optimizing a design with respect to cost is a five-step process.

1. Identify the design variable that is the primary cost driver. (e.g. pipe diameter
or insulation thickness).
2. Write an expression for the cost model in terms of the design variable.
3. Set the first derivative of the cost model with respect to the continuous design
variable equal to zero. For discrete design variables, compute the value of the
cost model for each discrete value over a selected range of potential values.
4. Solve the equation found in Step 3 for the optimum value of the continuous
design variable. For discrete design variables, the optimum value has the
minimum cost value found in Step 3. This method is analogous to taking the
first derivative for a continuous design variable and setting it equal zero to
determine an optimal value.
5. For continuous design variables, use the second derivative of the cost model
with respect to the design variable to determine whether the optimum value
found in Step 4 corresponds to a global maximum or minimum.
 Example 2-6
32

The cost of operating a jet-powered commercial (passenger-carrying) airplane

varies as the three-halves (3/2) power of its velocity; specifically, CO = knv3/2,
where n is the trip length in miles, k is a constant of proportionality, and v is
velocity in miles per hour. It is known that at 400 miles per hour, the average
cost of operation is $300 per mile. The company that owns the aircraft wants
to minimize the cost of operation, but that cost must be balanced against
the cost of the passengers’ time (CC), which has been set at $300,000 per
hour.
(a) At what velocity should the trip be planned to minimize the total cost,
which is the sum of the cost of operating the airplane and the cost of
passengers’ time?
(b) How do you know that your answer for the problem in Part (a)
minimizes the total cost?
 Example 2-6
33
(a) The cost model for total cost (CT) is…
𝑛
𝐶𝑇 = 𝐶𝑂 + 𝐶𝐶 = 𝑘𝑛𝑣 3/2 + ($300,000 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟)
𝑣
𝐶
𝐶𝑂 = 𝑘𝑛𝑣 3/2 𝑂
= 𝑘𝑣 3/2
𝑛
$300 𝑝𝑒𝑟 𝑚𝑖𝑙𝑒 = 𝑘 400 𝑚𝑝ℎ 3/2

$300 𝑝𝑒𝑟 𝑚𝑖𝑙𝑒 $300 𝑝𝑒𝑟 𝑚𝑖𝑙𝑒 ℎ𝑜𝑢𝑟𝑠 3/2

𝑘= = = $0.0375
400 𝑚𝑝ℎ 3/2 𝑚𝑖𝑙𝑒𝑠 3/2 𝑚𝑖𝑙𝑒𝑠 5/2
8,000
ℎ𝑜𝑢𝑟𝑠 3/2
3
ℎ𝑜𝑢𝑟𝑠 2 3 𝑛 𝑚𝑖𝑙𝑒𝑠
𝐶𝑇 = $0.0375 5 𝑛 𝑚𝑖𝑙𝑒𝑠 𝑣 𝑚𝑝ℎ 2 + ($300,000 𝑝𝑒𝑟 ℎ𝑜𝑢𝑟)
𝑣 𝑚𝑝ℎ
𝑚𝑖𝑙𝑒𝑠 2

𝑛
𝐶𝑇 = $0.0375𝑛𝑣 3/2 + $300,000
𝑣
 Example 2-6
34

3/2
𝑛
𝐶𝑇 = $0.0375𝑛𝑣 + $300,000
𝑣

𝑑𝐶𝑇 3 1/2
$300,000𝑛
= $0.0375 𝑛𝑣 − =0
𝑑𝑣 2 𝑣2

300,000
0.0562𝑣 1/2 − =0
𝑣2

0.0562𝑣 5/2 − 300,000 = 0

300,000
𝑣 5/2 = = 5,333,333
0.05625

𝑣 ∗ = (5,333,333)0.4 = 490.68 𝑚𝑝ℎ

 Example 2-6
35

(b) Second derivative to confirm a minimum cost solution…

𝑛
𝐶𝑇 = $0.0375𝑛𝑣 3/2 + $300,000
𝑣

𝑑𝐶𝑇 3 $300,000𝑛
= $0.0375 𝑛𝑣 1/2 −
𝑑𝑣 2 𝑣2
𝑑 2 𝐶𝑇 0.028125 600,000 𝑑 2 𝐶𝑇
= + 𝑓𝑜𝑟 𝑣 > 0, 𝑡ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒, >0
𝑑𝑣 2 𝑣 1/2 𝑣3 𝑑𝑣 2

The company concludes that v = 490.68 mph minimizes the total cost of this
particular airplane’s flight.
 Present Economy Studies

“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 are present and

vary among alternatives, choose the alternative that maximizes
RULE 1
overall profitability based on the number of defect-free units of
product or service produced
When revenue and other economic benefits are not present or
are constant among all alternatives, consider only the costs and
RULE 2
select the alternative that minimizes total cost per defect-free
unit of product or service output
 Example 2-8
37

Choosing the Most Economic Material for a Part

An annual demand for a part is 100,000 units. The part is produced on a high-
speed turret lathe, using 1112 screw-machine steel costing $0.30 per pound. A
study was conducted to determine whether it might be cheaper to use brass crew
stock, costing $1.40 per pound. Because the weight of steel required per piece
was 0.0353 pounds and that of brass was 0.0384 pounds, the material cost per
piece was $0.0106 for steel and $0.0538 for brass. However, when the
manufacturing engineering department was consulted, it was found that,
although 57.1 defect-free parts per hour were being produced by using steel, the
output would be 102.9 defect-free parts per hour if brass were used. Which
material should be used for this part?

Assume the machine attendant is paid $15.00 per hour, and the variable (i.e.,
traceable) overhead costs for the turret lathe are estimated to be $10.00 per
hour.
 Example 2-8
38

Choosing the Most Economic Material for a Part

1112 Steel Brass
Material $0.30 x 0.0353 = $0.0106 $1.40 x 0.0384 = $0.0538
Labor $15.00/57.1 = $0.2627 $15.00/102.9 = 0.1458
Variable Overhead $10.00/57.1 = $0.1751 $10.00/102.9 = $0.0972
Total cost per piece $0.4484 $0.2968
Saving per piece by use of brass = $0.448 - $0.2968 = $0.1516

Because 100,000 parts are made each year, revenues are constant across the
alternatives. Rule 2 would select brass, and its use will produce a savings of
$151.60 per thousand (a total of $15,160 for the year). It is also clear that costs
other than the cost of material (such as labor and overhead) were important in
the study.
Exercise 2 – Economic Considerations

As energy costs continue to rise, power efficiency is increasingly

important. Acme Chemical is evaluating two different electric motors to
drive a mixing motor and needs to perform a present economy study.
The motor will produce 75 hp and will be operated eight hours per day,
365 days for one year (maintenance will be performed on second shift—
assume no down time during operation), after which time the motor will
have no value. Select the most economical motor. Assume Acme’s
electric power costs $0.16 per kWh. 1 hp = 0.746 kW.

Motor A Motor B
Purchase price $3,200 $5,900
Annual maintenance cost $250 $450
Efficiency 75% 85%
Exercise 2 – Economic Considerations

Motor A

Motor B

Higher efficiency motor reduces running costs even though it may

means higher capital costs
 Example 3 – Copper Size

A constant electric current of 5,000 amps is to be transmitted a distance of

1,000 feet from a power station to a substation. Determine the optimal size of
the copper conductor.
• Copper price: $8.25/lb
• Resistance: 0.8145x10-5Ωin2/ft
• Cost of energy: $0.05/kWh
• Density of copper: 555 lb/ft
• Useful life: 25 years
• Salvage value: $0.75/lb
• Interest rate: 9%
 Example 3 – Copper Size

Operating Costs (Energy Loss)

I = current flow in amperes
I 2R
L= T R = resistance in ohms
1000 A T = number of operating hours
A = cross-sectional area
50002 (0.008145)
L= (24  365)
1000 A
1,783,755
= kWh
A
1,783,755
Energy loss cost = kWh($0.05)
A
$89,188
Operating Cost =
A
 Example 3 – Copper Size

Material Costs
• Material weight in pounds

1000(12)(555)A
3
= 3,854 A
12
• Material cost (required investment)
Total material cost = 3,854A($8.25)
= 31,797A
• Salvage value after 25 years: ($0.75)(3,854A)=$2,890.5A
 Example 3 – Copper Size

Capital Recovery Costs (Value of Money – Chapter 4)

Given:
2,890.5 A
Initial cost, I = $31,797A
0
Salvage value, S = $2,890.5A
Project life, n = 25 years 25
Interest rate, i = 9%
31,797 A
Find: CR(9%)
𝐶𝑅 𝑖 = (𝐼 − 𝑆)(𝐴Τ𝑃, 𝑖%, 𝑛) + 𝑆𝑖
𝐶𝑅 9% = (31,797𝐴 − 2,890.5𝐴)(𝐴Τ𝑃, 9%, 25) + 2,890.5𝐴(0.09)
𝐶𝑅 9% = 3,203𝐴 Material Cost
 Example 3 – Copper Size

Total Equivalent Economic Cost (Evaluating Project – Chapter 5)

 Total equivalent annual cost
AEC = Capital cost + Operating cost
= Material cost + Energy loss
 Find the minimum annual equivalent
cost

89,188
AEC(9%) = 3, 203 A +
A
dAEC(9%) 89,188
= 3, 203 −
dA A2
=0
89,188
A* =
3, 203
= 5.276 in 2
 Summary
46

 The term costs refers to all types of expenses including

capital, material, operational and maintenance.

 Costs can be either (1) fixed or variable, and (2) codirect or

indirect.

 Cost estimation is a major hurdle in economic analysis as

costs vary in time and uncertainty.