Chapter

COST CONCEPTS AND DESIGN ECONOMICS

2
OBJECTIVE:
The objective of Chapter 2 is to analyze short-term alternatives when the time
value of money is not a factor. We accomplish this with three types of problems:
(1.) Economic breakeven analysis;
(2.) Cost-driven design
(3.) Present economy studies
The word cost (or expense) has meanings that vary in usage. Cost concepts
and other economic principles used in an engineering economy study depend on
the situation and on the decision to be made. Many types of cost arise in economy
studies of a new existing enterprise whenever any change in operations or policy is
made. While an engineer may be cognizant of the various types of cost, it appears
that classifying the same and giving the applications of each will make them
clearer.

MANUFACTURING COSTS
The several types of manufacturing costs incurred by a typical manufacturer
are illustrated in Figure 2.1. In converting raw materials into finished goods, a
manufacturer incurs various costs of operating a factory. Most manufacturing
companies divide manufacturing costs into three broad categories: direct materials,
direct labor, and manufacturing overhead.
Contains Contains
inventory of inventory of
raw materials work in
process

Purchase of Raw materials Manufacturing

raw materials warehouse costs FACTORY

Raw materials
Raw materials
purchased Cost of finished
used Finished
Direct labor goods goods
Manufacturing manufactured
overhead

Cost of goods Finished goods

Contains
sold warehouse
inventory of
Consumer finished
s goods
Figure 2.1 Various types of manufacturing costs
11 | Chapter 2 - Cost Concepts and Design Economics

DIRECT MATERIALS
Direct raw materials refer to any materials that are used in the final
product and that can be easily traced into it. Some examples are wood in furniture,
steel in bridge construction, paper in printing firms, and fabric for clothing
manufacturers. It is also important to note that the finished product of one
company can become the raw materials of another company. For example, the
computer chips produced by Intel are raw materials used by Dell Computer in its
personal computers.

DIRECT LABOR
Like the term direct material, direct labor is for those labor costs that go
into the production of a product. The labor costs of assembly-line workers, for
example, would be direct labor costs, as would the labor costs of welders in metal
fabricating industries, carpenters or bricklayers in home building, and machine
operators in various manufacturing operations.

MANUFACTURING OVERHEAD
Manufacturing overhead include all costs of manufacturing except direct
materials and direct labor. In particular, they include such items as indirect
materials, indirect labor, maintenance and repairs on production equipment, heat
and light, property taxes, depreciation, insurance of manufacturing facilities, and
overtime premium. The most important thing to note about manufacturing
overhead is the fact that unlike direct materials and direct labor, it is not easily
traceable to specific units of output. In addition, many manufacturing overhead
costs do not change as output changes, as long as the production stays within the
capacity.

NON-MANUFACTURING COSTS
There are two additional costs in supporting any manufacturing operations.
They are (1) marketing or selling costs and (2) administrative costs. Marketing
or selling costs include all costs necessary to secure customer orders and get the
finished product or service into the hands of the customer.
 Overhead: Heat and light, property taxes, depreciation or similar terms,
associated with its selling and administrative functions.
 Marketing: Advertising, shipping, sales travel, sales commissions, and sales
salaries. Administrative costs include all executive, organizational, and
clerical costs associated with the general management of an organization.
 Administrative functions: Executive compensation, general accounting,
public relations, and secretarial support.

STANDARD COSTS
Standard costs are planned costs per unit of output that are established in
advance of actual production or service delivery. They are developed from
anticipated direct labor hours, materials, and overhead categories (with their
established cost per unit). Standard costs play an important role in cost control
and other management functions. Some typical uses are the following:
 Estimating future manufacturing costs
 Measuring operating performance by comparing actual cost per unit with the
standard unit cost
 Preparing bids on products or services requested by customers
 Establishing the value of work in process and finished inventories
12 | Chapter 2 - Cost Concepts and Design Economics

COST CLASSIFICATION FOR PREDICTING COST BEHAVIOR

In engineering economic analysis, we need to predict how a certain cost will
behave in response to a change in activity. For example, a manager will want to
estimate the impact a 5% increase in production will have on the company’s total
wages, before a decision to alter production is made.
Cost behavior describes how a cost item will react or respond to changes in
the level of business activity.

FIXED COSTS
Fixed costs are those unaffected by changes in activity level over a feasible
range of operations for the capacity or capability available. Typical fixed costs
include insurance and taxes on facilities, general management and administrative
salaries, license fees, and interest costs on borrowed capital.

VARIABLE COSTS
Variable costs are those associated with an operation that varies in total
with the quantity of output or other measures of activity level. Examples of these
costs are the costs of materials and labor used in a product or service.

INCREMENTAL COSTS
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.
This cost is often associated with “go-no go” decisions that involve a limited change
in output or activity level.

COST CONCEPTS RELEVANT TO DECISION MAKING

Costs are important feature of many business decisions. In making
decisions, it is essential to have a firm grasp of the concepts of differential cost,
opportunity cost, and sunk cost.

OPPORTUNITY COST
Opportunity cost may be defined as the potential benefit that is given up as
you seek an alternative course of action. It is incurred because of the use of limited
resources, such as the opportunity to use those resources to monetary advantage
in an alternative use is foregone. Thus, it is the cost of the best rejected (foregone)
opportunity and is often hidden or implied.
In economic sense, opportunity cost could mean the contribution to income
that is foregone by not using a limited resource in its best use. Or, we may view
opportunity costs as cash flows that could be generated from an asset the firm
already owns, provided they are not used for the alternative in question. In general,
accountants do not post opportunity cost in the accounting records of an
organization. However, this opportunity cost must be explicitly considered in every
decision.

SUNK COST
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.
We need to be able to recognize sunk costs and then handle them properly in an
analysis. Specifically, we need to be alert for the possible existence of sunk costs in
any situation that involves a past expenditure that cannot be recovered, or capital
that has already been invested and cannot be retrieved.
13 | Chapter 2 - Cost Concepts and Design Economics

LIFE-CYCLE COST
Life-cycle cost refers to a summation of all the costs related to a product,
structure, system, or service during its life span. It begins with identification of the
economic need or want (requirement) and ends with retirement and disposal
activities.
The cost elements of the life-cycle that need to be considered will vary with
the situation. Because of their common use, however, several basic life-cycle cost
categories will now be defined.
 Investment cost is the capital required for most of the activities in the
acquisition phase. This cost is also called a capital investment.
 Working capital refers to the funds required for current assets that are
needed for the start-up and support of operational activities. The amount of
working capital needed will vary with the project involved, and some or all of
the investment in working capital is usually recovered at the end of a
project’s life.
 Operation and Maintenance cost (O&M) include many of the recurring
annual expense items associated with the operation phase of the life cycle.
The direct and indirect costs of operation associated with the five primary
resource areas – people, machines, materials, energy, and information – are
major part of the costs in this category.
 Disposal cost includes those nonrecurring costs of shutting down the
operation and the retirement and disposal of assets at the end of the life
cycle.

THE GENERAL ECONOMIC ENVIRONMENT

There are numerous general economic concepts that must be taken into
account in engineering studies. In broad terms, economics deals with the
interactions between people and wealth, and engineering is concerned with the
cost-effective use of scientific knowledge to benefit humankind. Some of the basic
economic concepts will be discussed and how they may be factors for consideration
in engineering studies and managerial decisions.
The goods and services that are produced and utilized may be divided
conveniently into two classes.

Definition
Consumer goods and services are those products or services that are
directly used by people to satisfy their wants. Food, clothing, homes, cars,
television sets, haircuts, medical services are examples.
Producer goods and services are used to produce consumer goods and
services or other producer goods. Machine tools, factory buildings, buses, farm
machinery are examples. The amount of producer goods needed is determined
indirectly by the amount of consumer goods or services that are demanded by
people.

Much of our business activity, including engineering, focuses on increasing

the utility (value) of materials and products by changing their form or location.
14 | Chapter 2 - Cost Concepts and Design Economics

Definition
Utility is the power to satisfy human wants and needs. It is most
commonly measured in terms of value, expressed in some medium of exchange
as the price that must be paid to obtain the particular item.

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 all goods
and services, there is a relationship between the price that must be paid and the
quantity that will be demanded or purchased.
p

p = a – bD
Price

D
Units of Demand

Figure 2.2 – General Price-Demand Relationship

From Figure 2.2, as the selling price per unit (p) is increased, there will be
less demand (D) for the product, and as the selling price is decreased, the demand
will increase. The relationship between price and demand can be expressed as the
linear function

a
p  a  bD for 0  D  , and a  0, b  0, (2-1)
b

where a is the intercept on the price axis and b is the slope. Thus, b is the
amount by which demand increases for each unit decrease in p . Both a and b
are constants. It follows, of course, that

a p
D b  0 (2-2)
b
15 | Chapter 2 - Cost Concepts and Design Economics

BREAK-EVEN ANALYSIS

Definition
Break-even analysis involves investments of capital wherein at a
certain level of production, the total income of the company would just be equal
to the total expenses, thus resulting in no loss nor profit.

TOTAL REVENUE FUNCTION

The total revenue, TR, that will result from a business venture during a
given period is the product of the selling price per unit p and the number of units
sold D. Thus,

TR  price  demand  pD (2-3)

If the relationship between price and demand as given in Eq. 2-1 is used,

a
TR   a  bD  D  a  bD 2 for 0  D  , and a  0, b  0, (2-4)
b

The relationship between total revenue and demand for the condition
expressed in Eq. 2-4 may be represented by the curve shown in Figure 2.3. From
calculus, the demand 𝐷̂ that will produce maximum total revenue can be obtained
by solving

dTR
 a  2bD  0 (2-5)
dD

𝑎2 𝑎2 𝑎2
̂ − 𝑏𝐷
Maximum TR = 𝑎𝐷 ̂2 = − =
2𝑏 4𝑏 4𝑏
Total Revenue

Price = a – bD

𝑎
̂=
𝐷
2𝑏

Demand

Figure 2.3 – Total Revenue Function as a Function of Demand

16 | Chapter 2 - Cost Concepts and Design Economics

Thus,
𝑎
̂=
𝐷
2𝑏 (2-6)

It must be emphasized that, because of cost-volume relationships, most

businesses would not obtain maximum profits by maximizing revenue.
Accordingly, the cost-volume relationship must be considered and related to
revenue, because cost reductions provide a key motivation for many engineering
process improvements.

COST, VOLUME, AND BREAKEVEN POINT RELATIONSHIPS

Fixed costs remain constant over a wide range of activities, but variable
costs vary in total with the volume of output. Thus, at any demand D, total cost is

𝐶𝑇 = 𝐶𝐹 + 𝐶𝑉 , (2-7)

where 𝐶𝐹 and 𝐶𝑉 denote fixed and variable costs, respectively. For the linear
relationship assumed here,

𝐶𝑉 = 𝑐𝑣 ∗ 𝐷, (2-8)

where 𝑐𝑣 is the variable cost per unit.

SCENARIO 1: Demand is a Function of Price

When total revenue and total cost are combined, the typical results as a
function of demand are depicted in Figure 2.4. At breakeven point 𝐷1′, the total
revenue is equal to total cost, and an increase in demand will result in a profit for
the operation. Then at optimal demand, 𝐷 ∗ , profit is maximized. At breakeven
point 𝐷2′, total revenue and total cost are again equal, but additional volume will
result in an operating loss instead of a profit.

𝐶𝑇

Profit Loss
Cost and Revenue

𝐶𝑉

𝐶𝐹

𝐷1′ 𝐷∗ 𝐷2′
D
Demand
Figure 2.4 – Combined Cost and Revenue Functions, and Breakeven points,
As Functions of Volume, and Their Effect on Typical Profit (Scenario 1)
17 | Chapter 2 - Cost Concepts and Design Economics

Obviously, the conditions for which breakeven and maximum profit occur
are our primary interest. First, at any volume (demand), D,

Profit (Loss) = Total Revenue – Total Costs

= (𝑎𝐷 − 𝑏𝐷 2 ) − (𝐶𝐹 + 𝑐𝑣 𝐷)
𝑎
= −𝑏𝐷 2 + (𝑎 − 𝑐𝑣 )𝐷 − 𝐶𝐹 for 0 ≤ 𝐷 ≤ and 𝑎 > 𝑏, 𝑏 > 0. (2-9)
𝑏

In order for a profit to occur, based on equation 2-9, and to achieve the
typical results depicted in Figure 2.4, two conditions must be met:

1. (𝑎 − 𝑐𝑣 ) > 0; that is, the price per unit that will result in no demand has to be
greater than the variable cost per unit. (This avoids negative demand.)
2. Total revenue must exceed total cost for the periods involved.

If these conditions are met, we can find the optimal demand at which maximum
profit will occur by taking the first derivative of equation 2-9 with respect to D and
setting it equal to zero:

𝑑(profit)
= 𝑎 − 𝑐𝑣 − 2𝑏𝐷 = 0.
𝑑𝐷

The optimal volume D that maximizes profit is

𝑎 − 𝑐𝑣 (2-10)
𝐷∗ =
2𝑏

To ensure that we have maximized profit (rather than minimized it), the sign of the
second derivative must be negative. Checking this, we find that

𝑑 2 (profit)
= −2𝑏,
𝑑𝐷 2
which will be negative for 𝑏 > 0.

An economic breakeven point for an operation occurs when total revenue

equals total cost. Then for total revenue and total cost, as used in the development
of equation 2-9 and 2-10 and at any demand D,

Total revenue = Total cost (breakeven point)

𝑎𝐷 − 𝑏𝐷 2 = 𝐶𝐹 + 𝑐𝑣 𝐷
−𝑏𝐷 2 + (𝑎 − 𝑐𝑣 )𝐷 − 𝐶𝐹 = 0. (2-11)

Because equation 2-11 is a quadratic equation with one unknown (D), we can solve
for the breakeven points 𝐷1′ and 𝐷2′ (the roots of the equation):

−(𝑎 − 𝑐𝑣 ) ± √(𝑎 − 𝑐𝑣 )2 − 4(−𝑏)(−𝐶𝐹 )

𝐷′ = (2-12)
2(−𝑏)

With the conditions for a profit satisfied, the quantity in the brackets of the
numerator (the discriminant) in equation 2-12 will be greater than zero. This will
ensure that 𝐷1′ and 𝐷2′ have real positive, unequal values.
18 | Chapter 2 - Cost Concepts and Design Economics

Example 2.1
A company produces an electronic timing switch that is used in consumer and
commercial products. The fixed cost is Php730,000 per month, and the variable cost is
Php830 per unit. The selling price per unit is p=1800 – 0.2D. For this situation,
a. Determine the optimal volume for this product and confirm that a profit occurs
(instead of a loss) at this demand.
b. Find the volume at which breakeven occurs; that is, what is the range of
profitable demand?

 SOLUTION:
a. Profit = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
= 𝑝𝐷 − (𝐶𝐹 + 𝑐𝑣 𝐷)
= (1800 − 0.2𝐷)𝐷 − (730,000 + 830𝐷)
= 1800𝐷 − 0.2𝐷2 − 730,000 − 830𝐷
Profit = −0.2𝐷2 + 970𝐷 − 730,000

 Taking the first derivative of the equation and equating it to zero:

𝑑(Profit)
= −0.4𝐷 + 970 = 0
𝑑𝐷
−0.4𝐷 = −970
−970
𝐷= = 𝟐, 𝟒𝟐𝟓 𝐮𝐧𝐢𝐭𝐬
−0.4
 To confirm that a profit occurs, instead of a loss, we take the second derivative
of the profit equation:
𝑑2 (profit)
= −0.4 , Since the second derivative is negative (-), then the profit is
𝑑𝐷 2
maximized at 2,425 units.

−970±√(970)2 −4(−0.2)(−730,000)
b. 𝐷′ =
−2(0.2)
𝐷1′ = 931.47 and 𝐷2′ = 3,918.53
Thus, the range of profitable demand is 931.47 to 3,918.53 units per month.

Scenario 2: Price is Independent of Demand

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) = pD. 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 2.5.

Based on the definition of break-even and on the given assumptions, we have

the following equation:
Total Revenue = Total Costs
pD  CF  cv D
Combining similar terms will result in the following simplified equation:
D  p  cv   CF
Letting D’ be the point where break-even occurs, we will denote it as D’, and thus,
CF
D' 
p  cv
19 | Chapter 2 - Cost Concepts and Design Economics
TR
𝐶𝑇

Profit

Cost and Revenue

Breakeven Point

Loss 𝐶𝐹

𝐷′

Demand

Figure 2.5 – Typical Breakeven Chart with Price a Constant (Scenario 2)

Example 2.2
A firm has the capacity to produce 1 million units of a product per year. At
present, it is able to produce and sell only 600,000 units yearly at a total revenue of
Php720,000. Annual fixed costs are Php250,000 and the variable cost per unit is
Php0.70.
a. Calculate the firm’s annual profit or loss for this production.
b. How many units should be sold annually to break-even?
c. If the firm can increase its sales to 80% of full capacity, what will its profit or
loss be, assuming that its selling price and variable cost per unit remain
constant?
d. Draw a break-even chart indicating the above results on the chart.

 SOLUTION:
a. At 600,000 units of production (60% capacity)
Profit = Total revenue – Total costs
Profit = Php720,000 – [Php250,000 + (Php0.70/unit x 600,000 units)]
Profit = Php720,000 – Php670,000
Profit = Php50,000

b.
Total Revenue Php720,000
Computing for p =   Php1.20 per unit
Q 600,000 units
Php250,000
D'   500,000 units
(Php1.20 - Php0.70) per unit

c. At 80% capacity (800,000 units per year)

Profit = Total revenue – Total costs
Profit = (800,000 x Php1.20/unit) – [Php250,000 + (Php0.70/unit x 800,000)]
Profit = Php960,000 – Php810,000
Profit = Php150,000
20 | Chapter 2 - Cost Concepts and Design Economics

 SOLUTION:
d. Break-even chart
Php
1,200,000

1,100,000

1,000,000

Total
900,000
Revenues
800,000

700,000
Total costs
600,000

500,000

400,000

300,000

200,000 Fixed costs

100,000

Q
0 100,000 200,000 300,000 400,000 500,000 600,000 700,000 800,000 900,000 1,000,000

Example 2.3

An engineering consulting firm measures its output in a standard service hour unit,
which is a function of the personnel grade levels in the professional staff. The variable
cost is Php620 per standard service hour. The charge-out rate is Php855.60 per hour.
The maximum output of the firm is 160,000 hours, and its fixed cost is Php20,240,000
per year. For this firm,
a. what is the breakeven point in standard service hours and in percentage of total
capacity?
b. what is the percentage reduction in the breakeven point (sensitivity) if fixed
costs are reduced by 10%; if variable cost per hour is reduced by 10%; and if the
charge-out rate per hour is increased by 10%?
 SOLUTION:

CF 20, 240, 000

a. D'    85,908.32 hours
p  cv 855.60  620
85,908.32 hours
% capacity =  0.5369
160,000 hours
Or their BEP is 53.69% of their annual capacity.

b. If fixed costs will be reduced by 10%,

CF 0.90  20, 240, 000 
D'    77,317.49 hours
p  cv 855.60  620
85,908.32 hours  77,317.49 hours
% reduction in D' =  0.10
85,908.32 hours
 A 10% reduction in fixed cost resulted to 10% reduction in BEP.
21 | Chapter 2 - Cost Concepts and Design Economics

 SOLUTION:

If variable costs per hour will be reduced by 10%,

CF 20, 240, 000
D'    68, 010.75 hours
p  cv [855.60  0.90(620)]
85,908.32 hours  68, 010.75 hours
% reduction in D' =  0.2083
85,908.32 hours
 A 10% reduction in variable cost per hour resulted to 20.83% reduction in
BEP.

If charge-out rate per hour will be increased by 10%,

CF 20, 240, 000
D'    63, 021.55 hours
p  cv [1.10(855.60)  620]
85,908.32 hours  63, 021.55 hours
% reduction in D' =  0.2664
85,908.32 hours
 A 10% increase in charge-out rate per hour resulted to 26.64% reduction
in BEP.

Synthesis:
The breakeven point is more sensitive to a reduction on variable cost per hour
than to the same percentage reduction in the fixed cost. Furthermore, notice that the
BEP in this example is highly sensitive to the charge-out rate.
22 | Chapter 2 - Cost Concepts and Design Economics

NAME: _______________________________________ SCORE: ________________

COURSE/YEAR: _______________________________ DATE: _________________

EXERCISE 2

Analyze and solve the following problems.

1. A lash adjuster keeps pressure constant on engine valves, thereby

increasing fuel efficiency in automobile engines. The relationship between
price p and monthly demand D for lash adjusters made by the Wicks
(2000−𝑝)
Company is given by this equation: 𝐷 = . What is the demand when
0.10
total revenue is maximized? What important data are needed if maximum
profit is desired?

 SOLUTION:

2. A large company in the communication and publishing industry has

quantified the relationship between the price of one its products and the
demand for this product as Price = 150 – 0.01 x Demand for annual printing
of this particular product. The fixed costs per year (i.e., per printing) is
Php50,000 and the variable cost per unit is Php40. What is the maximum
profit that can be achieved if the maximum expected demand is 6,000 units
per year? What is the unit price at this point of optimal demand? What is
the range of profitable demand per year?

 SOLUTION:
23 | Chapter 2 - Cost Concepts and Design Economics

NAME: _______________________________________ SCORE: ________________

COURSE/YEAR: _______________________________ DATE: _________________

3. The annual fixed costs for a plant are Php100,000, and the variable costs
are Php140,000 at 70% utilization of available capacity, with net sales of
Php280,000. What is the breakeven point in units of production if the
selling price per unit is Php40.

 SOLUTION:

4. A telephone switchboard 100 pair cable can be made up with either

enameled wire or tinned wire. There will be 400 soldered connections. The
cost of soldering a connection on the enameled wire will be Php1.65 and on
the tinned wire it will be Php1.15. A 100-pair cable made up with enameled
wire costs Php0.55 per lineal foot and those made up to tinned wire costs
Php0.75 per lineal foot. Determine the length of cable run in feet so that the
cost of each installation would be the same. Determine also the length of
cable at which each alternative is more economical.

 SOLUTION:
24 | Chapter 2 - Cost Concepts and Design Economics

PRESENT ECONOMY STUDIES

When alternatives for accomplishing a specific task are being compared over
one year or less and the influence of time on money can be ignored, engineering
economic analyses are referred to as present economy studies. Several situations
involving present economy studies are illustrated here. The rules, or criteria, will
be used to select the preferred alternative when defect-free output (yield) is variable
or constant among the alternatives being considered.

When revenues and other economic benefits are present and vary
RULE 1: among alternatives, choose the alternative that maximizes overall
profitability based on the number of defect-free units of a product or
service produced.

When revenues and other economic benefits are not present or are
RULE 2: constant among all alternatives, consider only the costs and select the
alternative that minimizes the total cost per defect-free unit of product
or service output.

Present economy studies occur in the following situations:

Example 2.4 (Selection of Material)

A diesel engine uses Type A filter and high-grade lubricating oil costing Php5.50 per
liter. With this filter, the oil and the filter have to be changed every 500 hours of
operation, and 5 liters of oil have to be added every 100 hours. This filter costs Php148
a piece. Eighty liters of oil fill the engine. Another type, filter B, costing Php120 may be
used with a lower grade of oil costing Php4.80 per liter. However, if this filter is used,
the oil and filter have to be changed every 300 hours and 10 liters are added after each
150 hours the engine is used. Which type of filter and oil would you recommend?

 SOLUTION:
Set up a table to examine the total costs:
Cost Items Type A Filter Type B Filter
Cost of filter Php 148 Php 120
Initial Cost of oil 5.50/L x 80L = 440 4.80/L x 80L = 384
Additional Cost of oil 4 x 5.50/L x 5L = 110 1 x 4.80/L x 10L = 48
Total Cost Php 698 Phph 552
Lifespan (hours) 500 300
Cost per hour 698/500 = Php 1.396 552/300 = Php 1.84

It is more economical to use Type A Filter and Oil.

25 | Chapter 2 - Cost Concepts and Design Economics

Example 2.5 (Selection of Method)

A manufacturer has a contract to produce 5,000 units of a certain device. The device
can be made by highly-trained workmen working individually. The device can also be
made by less-skilled workmen working together if they are given specialized equipment
and proper supervision. The highly-trained workmen are paid Php20.00 per hour, and
each can produce one unit every 2 hours, on the average. The specialized equipment
can be placed in operation at an original cost of Php60,000 and it will be worthless at
the time all the 5,000 units are manufactured. With this equipment, four men, paid at
Php15.00 each per hour, and a foreman, paid at Php25.00 per hour, can do the work.
All the five men working together can finish one unit in 15 minutes. Determine the gain
or loss if the specialized equipment is used.

 SOLUTION:
Option 1 (Highly-trained workmen, no equipment):
2 hours
5,000 units x  10,000 hours
1 unit
Labor Cost = 10,000 hours (Php20/hour) = Php200,000

Option 2 (Less-skilled workmen + Specialized equipment):

15 mins. 1 hour
5,000 units x x  1, 250 hours
1 unit 60 mins.
Labor Cost = 1,250 hours [(4 x Php15/hr) + (1 x Php25/hr) = Php106,250
Total Cost = Labor Cost + Cost of Equipment
= Php106,250 + Php60,000
Total Cost = Php166,250

Gain = Php200,000 – Php166.250 = Php33,750

Therefore, the manufacturer can save Php33,750 if he use the specialized

equipment over the highly-trained workmen.

Example 2.6 (Site Selection)

A certain masonry dam requires 200,000 cu.m. of gravel for its construction. The
contractor found two possible sources for the gravel with the following data:
Source A Source B
Average distance (gravel pit to dam site) 3.0 km 1.2 km
Gravel cost (per cu.m.) - Php10.00
Purchase price of pit Php800,000 -
Road construction necessary Php450,000 -
Overburden to be removed
(at Php4.20 per cu.m.) - 90,000 cu.m.
Hauling cost per cu.m.-km Php4.00 Php4.00

Which of the two sites will give lesser cost?

26 | Chapter 2 - Cost Concepts and Design Economics

 SOLUTION:

Cost Items Source A Source B

Gravel cost - Php2,000,000
200,000 cu.m. x Php10/cu.m
Purchase price of pit Php800,000 -
Road construction 450,000 -
Cost of removing overburden 378,000
90,000 cu.m x Php4.20/cu.m
Hauling cost Php4/cu.m-km x Php4/cu.m-km x
200,000cu.m x 3.0 km 200,000cu.m x 1.2 km
=Php2,400,000 =Php960,000
TOTAL COST Php3,650,000 Php3,338,000

It is more economical to get gravel from Source B.

Example 2.7 (Economy of Tool and Equipment Maintenance)

A machine used for cutting materials in a factory has the following outputs per hour at
various speeds and requires periodic tool regrinding at the interval cited.
Speed Output per hour Tool regrinding
A 200 pieces every 8 hours
B 250 pieces every 7 hours
C 280 pieces every 5 hours
A set of tools costs Php1,800 and can be ground twenty times. Each regrinding costs
Php18.00 and the time needed to regrind and change tools is 1 hour. The machine
operator is paid Php28.00 per hour, including the time the tool is changed. The tool
grinder who also sets the tools to the machine is paid Php25.00 per hour. The hourly
rate chargeable against the machine is Php54.00, regardless of machine speed. Which
speed is the most economical?

 SOLUTION:

In this example, it is better to do the analysis in per grinding (or regrinding).

Cost Items Speed A Speed B Speed C
Tool Cost Php90 Php90 Php90
(Php1,800/20)
Regrinding cost 18 18 18
Operator cost (Php28/hr)(8 + 1)hr (Php28/hr)(7 + 1)hr (Php28/hr)(5 + 1)hr
= 252 = 224 = 168
Tool grinder cost 25 25 25
Machine cost (Php54/hr)(8 hrs) (Php54/hr)(7 hrs) (Php54/hr)( 5hrs)
= 432 = 378 = 270
TOTAL COST Php 817 Php 735 Php 571
Output per grind 8(200 pcs/hr) = 7(250 pcs/hr) = 5(280 pcs/hr) =
1,600 pcs 1,750 pcs 1,400 pcs
Cost per piece Php817/1,600 = Php735/1,750 = Php571/1,400 =
Php0.51 Php0.42 Php0.41

It is most economical to operate at Speed C.

27 | Chapter 2 - Cost Concepts and Design Economics

Example 2.8 (Economy in the Utilization of Personnel)

A contractor has a job which should be completed in 100 days. At present, he has 80
men on the job and it is estimated that they will finish the work in 130 days. Of the 80
men, 50 are each paid at Php220.00 a day, 25 at Php280.00 a day, and 5 at
Php350.00 a day. For each day beyond the original 100 days, the contractor has to
pay Php500.00 liquidated damages.
a. How many more men should the contractor add so that he can complete the
work on time?
b. If of the additional men, 2 are paid Php280.00 a day and the rest at
Php220.00 a day, would the contractor save money by employing more men
and not paying the fine?
 SOLUTION:
a. The number of additional men needed can be determined using the man-day
relationship:
Let: n = number of additional men needed
(80 men)(130 days) = (80 + n men)(100 days)
10,400 men-days = 8,000 men-days + 100n
100n  2, 400
n  24
b. Option 1 (Do not add men, pay the fine)
Total Cost = Labor Cost + Fine
= 130 days[(50xPhp220/day)+(25xPhp280/day)+(5xPhp350/day)] +
Php500/day (30 days)
Total Cost = Php2,567,500 + Php15,000 = Php2,582,500
Option 2 (Add more men)
Total Cost = 100 days[(72xPhp220/day)+(27xPhp280/day)+(5xPhp350/day)]
Total Cost = Php2,515,000

The contractor will save Php67,500 if he will employ enough men, than paying
the fine.
28 | Chapter 2 - Cost Concepts and Design Economics

NAME: _______________________________________ SCORE: ________________

COURSE/YEAR: _______________________________ DATE: _________________

EXERCISE 3

Analyze and solve the following problems.

1. Two alternative designs are under consideration for a tapered fastening pin.
The fastening pins are sold for Php0.70 each. Either design will serve
equally well and will involve the same material and manufacturing cost
except for the lathe and drill operations. Design A will require 16 hours of
lathe time and 4.5 hours of drill time per 1,000 units. Design B will require
7 hours of lathe time and 12 hours of drill time per 1,000 units. The
variable operating cost of the lathe, including labor, is Php18.60 per hour.
The variable operating cost of the drill, including labor, is Php16.90 per
hour. Finally, there is a sunk cost of Php50,000 for Design A and Php9,000
for Design B due to obsolete tooling.
a. Which design should be adopted if 125,000 units are sold each year?
b. What is the annual saving over the other design?
 SOLUTION:
29 | Chapter 2 - Cost Concepts and Design Economics

NAME: _______________________________________ SCORE: ________________

COURSE/YEAR: _______________________________ DATE: _________________

2. A bicycle component manufacturer produces hubs for bike wheels. Two

processes are possible for manufacturing, and the parameters of each
process are as follows:
Process 1 Process 2
Production rate 35 parts/hour 15 parts/hour
Daily production time 4 hours/day 7 hours/day
% of parts rejected based on 20% 9%
visual inspection
Assume that the daily demand for hubs allows all defect-free hubs to
be sold. Additionally, tested or rejected hubs cannot be sold. Find the
process that maximizes profit per day if each part is made from Php40 worth
of material and can be sold for Php300. Both processes are fully automated,
and variable overhead cost is charged at the rate of Php400 per hour.

 SOLUTION:
30 | Chapter 2 - Cost Concepts and Design Economics

NAME: _______________________________________ SCORE: ________________

COURSE/YEAR: _______________________________ DATE: _________________

3. One method for developing a mine containing an estimated 100,000 tons of

ore will result in the recovery of 62% of the available ore deposit and will
cost Php23 per ton of material removed. A second method of development
will recover only 50% of the ore deposit, but it will cost only Php15 per ton of
materials removed. Subsequent processing of the removed ore recovers 300
pounds of metal from each ton of processed ore and costs Php40 per ton of
ore processed. The recovered metal can be sold for Php0.80 per pound.
Which method for developing the mine should be used if your objective is to
maximize total profit from the mine?
 SOLUTION: