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IE 371
Engineering Economics
Chapter 1: Introduction to Engineering Economics
Chapter 2: Engineering Costs, Revenue, Profit (Loss)
Concepts

Department of Industrial Engineering

Dr. Rula Allaf

Learning Objectives
 Understand the role and purpose of
engineering economic analysis
 Understand various cost concepts
 Understand revenue and profit concepts

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Engineering
Profession in which a knowledge of the mathematical
and natural sciences gained by study, experience, and
practice is applied with judgment to develop ways to
utilize, economically, the materials and forces of nature
for the benefit of mankind.
(Accreditation Board for Engineering and Technology; ABET)

Economics
The study of how people choose to use resources;
including available time, land, buildings, equipment, other
tools on hand, and the knowledge of how to combine
them to create useful products and services.
(American Economic Association)
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Engineering economics…
The application of economic techniques to the
evaluation of design and engineering alternatives.
– Engineering economy primarily focuses on equipping
engineers with the tools needed to economically
justify technical decisions.
– A systematic tool for comparing alternatives by their
economic merits.
– Focuses on costs, revenues, and benefits that occur at
different times.
– Could apply to Product/Process Design, Purchase of
Capital Equipment, Selection of Projects, Investment,
and many other decision-making processes.
– Answer to: Do benefits exceed costs?
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Rational Decision-Making Process

1. Recognize Problem / Opportunity
Overall Mission /
Objectives
2. Define Goals/Objectives

3. Assemble Relevant Data 5. Select the Criterion

4. Identify Feasible Alts 6. Construct a Model

7. Predict Alts’ Outcomes

9. Audit the Results 8. Choose the Best Alt.

Types of Costs
 Fixed Costs & Variable Costs
 Marginal Costs
 Average Costs
 Direct Costs & Indirect Costs
 Standard Costs
 Sunk Costs
 Opportunity Costs
 Recurring & Non-recurring Costs
 Incremental Costs
 Cash Costs & Book Costs
 Life-Cycle Costs
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Fixed Costs & Variable Costs

Marginal Costs & Average Costs
 Fixed Costs: constant, independent of the output or
activity level (within a range of available capability or
capacity).
◦ Property taxes, insurance
◦ Management and administrative salaries
◦ Interest costs on borrowed capital
◦ Rental or lease
 Variable Costs: Proportional to the output or activity
level.
◦ Direct labor cost
◦ Direct materials
 Marginal* Costs: the variable cost for one more unit
of output. * In Book, Sullivan calls is incremental cost
 Average Costs: total cost divided by the total
number of units produced.
◦ Basis for normal pricing 7

Direct Costs & Indirect Costs

Standard Costs
 Direct cost: can be measured and
allocated to a specific work activity
 Indirect cost: 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; developed from
anticipated labor hours, materials, overhead
with their established costs per unit. 8

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Sunk Costs & Opportunity Costs

Recurring Costs & Non-recurring Costs
 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.
− Purchasing price of laptop in deciding on opportunity to sell it
few years later
 Opportunity cost: Cost of the foregone opportunity and is
hidden or implied
– Going to graduate school implies lost income

 Recurring Costs: Repetitive and occur when a firm

produces similar goods and services on a continuing basis
◦ Office space rental
 Non-recurring Costs: Not repetitive
◦ Typically involve developing or establishing a capacity to operate
◦ Examples are purchase and installation costs of a new machine and
the construction costs of the plant 9

Incremental Costs
Cash Costs & Book Costs
 Incremental Costs: Difference in costs (cost items)
between two alternatives. Negative costs mean savings
◦ Suppose that A and B are mutually exclusive alternatives.
If A has an initial cost of $10,000 while B has an initial
cost of $14,000, the incremental initial cost of choosing B
instead of A (B cost- A cost) is $4,000.
 Cash cost: a cost that involves a payment of cash
(money/cash transaction)
◦ Interest payments, taxes, etc.
 Book cost: a cost that does not involve a cash
transaction but is reflected in the accounting system; cost
effects from past decisions that are recorded “in the
books” of a firm
◦ Depreciation is charged for the use of assets, such as equipment 10

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Life-cycle Costs
 Life-cycle cost: the summation of all
costs related to a product, structure,
system, or service during its life span.
 Phases of Life Cycle
1. Need 2.Conceptual 3. Detailed 4. Production 5.Operational 6. Decline/
Assessment Design Design /Construction /Use Retirement

 Investment cost (capital cost)

 Operation and maintenance cost
 Disposal cost

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“Present economy studies” can ignore the time

value of money: Current Costs.
 Alternatives are being compared over one year or less/
short period of time, costs and benefits can be added up
quickly
 Using suitable economic criterion, the best alternative can
be identified.
 When revenues and other economic benefits vary among
alternatives, choose the alternative that maximizes overall
profitability of defect-free output.
 When revenues and other economic benefits are not
present or are constant among alternatives, choose the
alternative that minimizes total cost per defect-free unit.
 Profit (loss) = total revenue – total costs
 Revenue = price x demand,
 Cost= fixed costs + variable costs=fixed costs+ unit cost x demand
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Example 2-1
GJU wants to offer a one-day training course to help students in
job hunting and to raise funds. The organizing committee is sure
that they can find alumni, local business people, and faculty to
provide the training at no charge. Thus the main costs will be
for space, meals, handouts, and advertising.
The organizers have considered a room that holds 40 people, and
calculated room rental, room setup, and advertizing costs as
$225.
The costs for food and bound handouts will be $20 per student.
The organizing committee believes that $35 is about the right
price to match value to students with their budgets. Since GJU
has not offered this course before, they are unsure how many
students will reserve seats.
Develop equations for GJU total cost and total revenue, and
determine the number of registrations that would be needed
for revenue to equal cost.

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Example 2-1
 Costs
◦ Room rental and setup (40 student)= $225
◦ Food and handouts/student = $20
 Revenues
◦ Price/student =$35

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Example 2-1:Solution
• Total Variable Cost = Unit Variable Cost * Demand
CV = c V * D
• Total Cost = Fixed Cost + Total Variable Cost
CT = CF + c V * D
• Total Revenue = Unit Selling Price * Demand
TR = p * D
where CV = Total variable cost
cV = Variable cost per unit
D = Production/Selling quantity
CF = Fixed costs
TR = Total revenue
p = Selling price per unit

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Example 2-1:Solution
Price and demand are not related, p > cv

Profit (Loss)  TR  CT
 pD  [C F  cv D]
  p  cv D  C F
• Breakeven point: the output level at which total
revenue is equal to total cost.
p * D′ = CF + cV * D′
D′ = CF / (p - cV)
where D′ = breakeven point
CF = fixed costs
p = selling price per unit
cV = variable cost per unit
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Example 2-1

Total Revenue
$1000 = 35X

Profit Total Costs

$800
= $225 + 20X

Variable Costs
$600
= 20X
Question:
$400
Marginal cost?

Fixed Costs Average cost?

$200
Loss = $225
If # of
X students=15
$0
5 10 15 20 25 # of Customers

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