ES 312b - Engineering Economy 1st Sem, S.Y.

2020-2021

MODULE 2

Cost Concepts and Economic Environment

After completing this module, you are expected to:

1. Understand the basic cost terminologies
2. Understand economic concepts

A. Fixed, Variable and Incremental Cost

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 varies in total with
the quantity of output or other measures of activity level.

An incremental cost (or incremental revenue) is the additional cost (or revenue)
that results from increasing the output of a system by one (or more) units.

READ (IMPORTANT!)

• Page 21 to 22
Textbook: Engineering Economy,
16th Edition

Example:
In connection with surfacing a new highway, a contractor has a choice of two sites on
which to set up the asphalt-mixing plant equipment. The contractor estimates that it will
cost $2.75 per cubic yard mile (yd 3-mile) to haul the asphalt-paving material from the
mixing plant to the job location. Factors relating to the two mixing sites are as follows
(production costs at each site are the same):
Cost Factor Site A Site B
Average hauling distance 4 miles 3 miles
Monthly rental of site $2,000 $7,000
Cost to set up and remove equipment $15,000 $50,000
Hauling expense $2.75/ yd3-mile $2.75/ yd3-mile
Flagperson Not Required $150/day

The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated

that four months (17 weeks of five working days per week) will be required for the job.

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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

Compare the two sites in terms of their fixed, variable, and total costs. Assume that the
cost of the return trip is negligible. Which is the better site? For the selected site, how
many cubic yards of paving material does the contractor have to deliver before starting
to make a profit if paid $12 per cubic yard delivered to the job location?

Identify the Fixed Cost and the Variable Cost

Rent – This type of cost is a fixed cost. The job (hauling) is fixed for four (4) months, any
changes in activity level will never result in change of the monthly cost.
Site A: (4 months) x ($2,000/month) = $8,000
Site B: (4 months) x ($7,000/month) = $28,000

Set-up/Removal – This type of cost is a fixed cost. For the entirety of the job, the cost of
setting and removal of equipment (Mobilization and Demobilization) is fix at $15,000 for
site A and $50,000 for site B. No amount of change in activity during the duration of the
project will cause this cost to change.

Flagperson – This type of cost is a fixed cost. It is stated in the problem that the duration
of the job is 17 weeks with 5 working days per week. Site A does not require any
flagperson while Site B needs flagperson which is fixed at $150/day. This cost (salary of
flagperson) is unaffected by any changes in activity level over the course of 17 weeks.
Site A: Flagperson not needed = $0
Site B: (17 weeks) x (5 days/week) x ($150/day) = $12,750

Hauling – This type of cost is a variable cost. This cost varies with the total number of
cubic yards. It is stated in the problem that the required mixed-asphalt-paving material is
about 50,000 yd3. Although this was stated, this is actually just an estimate. The real
amount of hauled material will always be determined at the end of the job, it can be more
than or less than 50,000 yd3. Since, there is this problem of which site to choose, we will
use the estimated 50,000 yd3 as basis for our decision.
Site A: (4 miles) x ($2.75/ yd3-mile) x (50,000 yd3) = $ 550,000
Site B: (3 miles) x ($2.75/ yd3-mile) x (50,000 yd3) = $ 412,500

Cost Fixed Cost Variable Cost Site A Site B

Rent ✓ $8,000 $28,000
Set-up/Removal ✓ $15,000 $50,000
Flagperson ✓ $0 $12,750
Hauling ✓ $ 550,000 $ 412,500
Total $573,000 $503,250

The result shows that site B is cheaper than site A. Although the fixed cost is more
expensive in site B the variable cost of hauling was affected by the distance of site B (1
mile lesser than site A) to the project.
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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

B. Direct, Indirect, Overhead and Standard Costs

READ (IMPORTANT!)
• Page 23
Textbook: Engineering Economy,
16th Edition

Direct costs are costs that can be reasonably measured and allocated to a
specific output or work activity.

Example:
Material cost of a building construction
Labor cost of a building construction
Cost of ingredients for a Dish
Cost of raw materials of a factory

Indirect costs are costs that are difficult to allocate to a specific output or work
activity.

Example:
Cost of a safety and health program – it can be a percentage of
labor cost of a construction project.

Overhead cost consists of plant operating costs that are not direct labor or direct
material costs.

Example:
Contractor’s Profit
Real Estate/Property Tax
Cost of Mobilization/Demobilization for Equipment
Cost of Temporary Housing for Labors
Cost of Temporary Utilities

Standard costs are planned costs per unit of output that are established in
advance of actual production or service delivery. This is the total cost divided by
the planned unit of output

Example: Cost of constructing a low – end residential building in the

Philippines is about Php 25,000 to Php 30,000 per sq. meter.
Cost of manufacturing a 1-liter beer is about Php 65.28 per bottle

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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

C. Sunk and Opportunity Costs

READ (IMPORTANT!)

• Page 24-25
Textbook: Engineering Economy,
16th Edition

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.

Example:
Ricky wants to buy the old model Yamaha Mio scooter with a price tag of Php 75,900
and down payment of Php 3,800. He then decides to pay the down payment of Php
3,800 and will pay periodically the remaining balance of Php 72,100. The release of
the scooter is one week after paying of the down payment. Next day, he saw the
latest Honda Beat scooter with a price tag of only Php 70,400. For the purpose of
deciding which scooter to purchase, the Php 3,800 is a sunk cost and thus would
not enter into the decision, except that it lowers the remaining cost of the first scooter
(Yamaha Mio). The decision then is between paying an additional Php 72,100 (Php
75,900 − Php 3,800) for the first scooter versus Php 70,400 for the second scooter.
If Ricky chooses to go with the second scooter (Honda Beat), the Php 3,800 he paid
as a downpayment will be irretrievable.

An opportunity cost is incurred because of the use of limited resources, such that the
opportunity to use those resources to monetary advantage in an alternative use is
foregone. Thus, it is the cost of the best rejected (i.e., foregone) opportunity and is often
hidden or implied.
Example:
Sarah, a student, could earn a decent salary working as a full-time minute burger
crew. Her salary for the whole year is about Php 97,032 (Php 311/day). Although
the salary is good, she still chooses to go to a private school whose yearly tuition is
Php 30,000. Based on this:
Opportunity Cost of Going to School: Php 97,032 + Php 30,000 = Php 127,032
Cash Outlay (Outgoing): Php 30,000
Income Foregone: Php 97,032

Thus, Sarah should do her best in her school because the opportunity cost is
expensive.

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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

Consumer and Producer Goods and Services

The goods and services that are produced and utilized maybe divided conveniently into
two classes.
1. Consumer goods and services are those products or services that are directly
used by people to satisfy their wants.
Examples: Food
Clothing
Homes
Cars
Internets
Haircuts
Cellular Loads
Medical Services
The providers of consumer goods and services must be aware of, and are subject
to, the changing wants of the people to whom their products are sold.

2. Producer goods and services are used to produce consumer goods and services
or other producer goods.
Examples: Machine tools
factory buildings
buses
farm machinery
The amount of producer goods needed is determined indirectly by the amount of
consumer goods or services that are demanded by people. However, because the
relationship is much less direct than for consumer goods and services, the demand
for and production of producer goods may greatly precede or lag behind the
demand for the consumer goods that they will produce.
Necessities, Luxuries, and Price Demand

READ (IMPORTANT!)

• Page 28-29
Textbook: Engineering Economy,
16th Edition

Goods and services may be divided into two types: necessities and luxuries. Obviously,
these terms are relative, because, for most goods and services, what one person
considers a necessity may be considered a luxury by another. For example, a person
living in one community may find that an automobile is a necessity to get to and from

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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

work. If the same person lived and worked in a different city, adequate public
transportation might be available, and an automobile would be a luxury.
Competition
Perfect competition occurs in a situation in which any given product is supplied by a large
number of vendors and there is no restriction on additional suppliers entering the market.
Monopoly is at the opposite pole from perfect competition. A perfect monopoly exists
when a unique product or service is only available from a single supplier and that vendor
can prevent the entry of all others into the market.

SUMMARY:
It is important to understand the different terminologies used in engineering economy.
The first example illustrates the difference of fixed and variable cost. The varying amount of
materials to be hauled will be the basis of the contractor on decisions. This is important in
engineering economy to determine what cost is the variable. An incremental cost (or incremental
revenue) is the additional cost (or revenue) that results from increasing the output of a system by
one (or more) units.
The direct, indirect, overhead and standard cost have been explained thru series of
examples. The standard cost is an estimate and is the total of the three cost (direct, indirect,
overhead) divided into the planned unit of output.
The sunk cost are irretrievable consequences of past decisions and therefore are irrelevant
in the analysis and comparison of alternatives that affect the future.
The opportunity cost is the best rejected opportunity cost which is often hidden or implied
Consumer goods and services are those products or services that are directly used by
people to satisfy their wants.
Producer goods and services are used to produce consumer goods and services or other
producer goods.
Necessities and Luxuries are defined by who will used it, some people consider luxury as
necessity and vice versa.
Price and Demand for every increase of selling price the demand will decrease.
Perfect Competition occurs in a situation in which any given product is supplied by a large
number of vendors and there is no restriction on additional suppliers entering the market.
Perfect Monopoly exists when a unique product or service is only available from a single
supplier and that vendor can prevent the entry of all others into the market.

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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

EXERCISES:
NOTE: For VLE Students – No need to answer the problems here. What you need to do
is to solve the exercises in the VLE.
The exercises here are to be DONE ONLY by students who choose the “Printed
Module” mode of delivery. The solutions to this problem are to be handwritten and to
be passed to your instructor a week after you received this printed module.
SHOW YOUR SOLUTIONS.
Problem 1: Refer to the example from the topic about fixed and variable cost
1. How many cubic yards of material (X) will the contractor haul in order to begin
making a profit for site A?
2. How many cubic yards of material (X) will the contractor haul in order to begin
making a profit for site B?

Problem 2: Classify each of the following cost items as mostly fixed or variable:
Raw materials Administrative salaries
Direct labor Payroll taxes
Depreciation Insurance (building and equipment)
Supplies Clerical salaries
Property taxes Sales commissions
Interest in borrowed money Rent

Problem 3: A group of enterprising engineering students has developed a process for

extracting combustible methane gas from cow manure (don’t worry, the exhaust is
odorless). With a specially adapted internal combustion engine, the students claim that
an automobile can be propelled 15 miles per day from the “cow gas” produced by a single
cow. experimental car can travel 60 miles per day for an estimated cost of $5 (this is the
allocated cost of the methane process equipment—the cow manure is essentially free)
1. How many cows would it take to fuel 1,000,000 miles of annual driving by a
fleet of cars?
2. What is the annual cost of using the “cow gas”?
3. Compare the annual cost of “cow gas” to that of a gasoline-fueled car averaging
30 miles per gallon when the cost of gasoline is $3.00 per gallon ?
Problem 4: John Bros, owner of a spark manufacturing facility, is looking to expand his
production capacity. He is considering three location s A, B, and C for the construction of
a new plant. The company wishes to find the most economical location for an expected
volume of 2,500 units per year. Bros calculates that the fixed costs per year at each of
the sites amount to $25,000, $50,000 and $100,000 respectively. The variable cost is $70

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Engr. Ryan James S. Olivo
ES 312b - Engineering Economy 1st Sem, S.Y. 2020-2021

per unit, $40 per unit and $20 per unit respectively. The expected selling price for each
spark plug is $120.
1. Find the most economical location .
2. How many units of spark plug (X) will the company manufacture in order to begin
making a profit for site A?
3. How many units of spark plug (X) will the company manufacture in order to begin
making a profit for site A?
4. How many units of spark plug (X) will the company manufacture in order to begin
making a profit for site A?

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Engr. Ryan James S. Olivo