L5 - Types of Costs and Cost Estimation of A Product

College of Engineering
Department of Mechanical Engineering
Process planning & product costing (MEng 5322)

L5- Types of Costs and Cost Estimation of a Product
Prepared by Gebre F.
September 2022
Learning objectives
Students are able to know
 Understanding costs in manufacturing &

selecting economical process and equipment.
03/09/2022 2
Introduction
➢ Manufacturing costs play an important part in the
successful design and manufacture of a product.
➢ Based on the model of added value, the manufacturing

costs must be less than the value added to allow a profit
to be made.
➢ Costs are very often used for making decisions for the
design and manufacture of a product.
9/3/2022 3
Introduction Contd.
❖The types of decisions that can be made based on costs
are:
✓ The type of material to be used for a product
✓ The type of manufacturing process to be used for a
product.
✓ How many of a product to manufacture.
✓ Whether to make or buy in a product/part.
✓ The design of a product.
9/3/2022 4
Manufacturing Costs
❖ What do manufacturing organizations use financial
information for?
➢ Manufacturing organization must use financial information
& techniques for three basic purposes:
1. Control– to help control the manufacturing system

efficiently, including the preparation of budgets & cost
analysis.
➢The manufacturing engineer carries out a cost

analysis during the process planning phase.
9/3/2022 5
Manufacturing Costs
2. Decision making– based on proposed or alternative
courses of action, probable costs and effects on profits are
analyzed (‘what if’)
➢Activities carried out during the process plan include:
✓ the type of manufacturing process to be used,
✓ the quantity to be produced,
✓ whether to ‘make or buy’ a component and
✓ the type of material to be used.
9/3/2022 6
Manufacturing Costs Contd.
3. Reporting and recording- involves the compilation and

upkeep of financial records and statements such as profit
and loss accounts and for tax purposes and monthly
management accounts.
9/3/2022 7
What Costs are Associated With Manufacturing?
❖Various costs contribute towards the selling price of a

finished product.
➢ Manufacturing costs
➢ Design/R&D costs
➢ Overheads (typically marketing, sales, customer service

and administration costs) and
➢ The profit margin
9/3/2022 8
Contd.
 Manufacturing costs are shown below with typical

percentages used to show the contribution each makes to
the final selling price.
Figure 1- Cost elements of product selling price.

9/3/2022 9
Contd.
➢Manufacturing cost is the single largest cost element in the
selling price and can be broken down further into four main
elements as illustrated in Figure 2, with a typical
percentages.
Figure 2- Elements of manufacturing costs.
9/3/2022 10
Contd.
➢ Throughout the analysis procedure, the planner will

compile a manufacturing cost estimate for the
product/component.
➢ These estimates must be made to allow management to

determine the potential profitability of a product.
9/3/2022 11
Contd.
➢ The main costs that the process planner is concerned with
are those related to:
✓ the production costs and
✓ product volumes
➢ The accuracy of the process plan will have a major

influence on the organization’s profit.
9/3/2022 12
Contd.
If the planner’s estimate of the manufacturing costs is
accurate, the organization will make a profit on the
financial outlay.
If the estimate of manufacturing costs is too high, the
company may decide to shelve production of a potentially
profitable product.
If the estimate is too low, the company will end up

producing a non-profit making product.
o In either case, the company is closer to economic failure.
9/3/2022 13
Cost Categories
##. Variable and fixed costs
➢ The costs involved in producing a product can be
classified as one of two categories:
➢Variable costs– related directly to the quantity

produced.
✓ These are traditionally taken to be
o Production labor and
o Production materials
o It is also termed as direct costs.
9/3/2022 14
Cost Categories Contd.
❖Fixed costs– independent of the quantity produced and
cannot be allocated to any specific item produced.
➢ They include everything that cannot be classified as a
variable cost.
✓ Examples- are occupancy and financing costs,

administration and items such as postage, telephones
and stationery.
9/3/2022 15
➢ Fixed cost also includes depreciation of plant and
machinery.
➢ Depreciation is a charge made for the value of plant used

up in producing goods/services, on the basis that at the
end of plant life the residual value will be ‘scrap’, or in the
worst case a charge for dismantling and disposal.
➢ Fixed costs are also termed as indirect costs.
9/3/2022 16
Table 1- Typical fixed and variable costs
9/3/2022 17
❖ Direct costs
 Direct costs are the costs of the organization that can be
directly attributed to the manufacture of a specific
product.
➢ There are three elements to direct costs:
✓ Direct labor costs;
✓ Direct material costs;
✓ Any other expense that can be directly attributed to

the manufacture of a product
9/3/2022 18
 Direct labor is all the labor used to work directly on the
product.
✓Examples of these are machine operators and assemblers.
➢ This cost can be found by multiplying the direct workers’

hourly wage rate by the number of hours spent working
on the product, that is,
Direct labor cost = Hourly rate x Direct labor hours
9/3/2022 19
Example 1;
➢A small drive shaft is produced using a CNC lathe.
➢The machine operator’s hourly rate is 8.30 Birr per hour.
➢The time taken to machine the drive shaft is 15min.
➢The order is for 1500 units.
➢Calculate the direct labor cost for producing the drive
shafts.
9/3/2022 20
Solution
➢ Hourly rate = 8.30 Birr/Hr
➢ Direct labor hours = 1500 x (15/60) Hr
= 375 Hr
➢ Direct labor cost = Hourly rate x Direct labor hours
= 8.30 Birr/Hr x 375 Hr
= 3112.50 Birr
9/3/2022 21
Direct material is all the material purchased and used in
the finished product, including any scrap/waste incurred.
✓ Examples of these are sheet steel and sub-assemblies
for the automobile industry.
➢ This can be calculated by multiplying the material cost per

unit by the number of units produced, that is,
Direct material cost = Material cost/unit*Number of units

produced
9/3/2022 22
Example 2
In Example 1, the steel billet used for manufacturing the
drive shaft costs 1.67 Birr per unit (the order is for 1500
units) including chuck allowance and scrap.
 Calculate the direct material costs.
9/3/2022 23
Solution
➢ Material cost/unit = 1.67 Birr
➢ Number of units = 1500
➢ Direct material cost
= Material cost/unit X Number of units
= 1.67 Birr x 1500
= 2505.00 Birr
9/3/2022 24
❖ Indirect costs
✓ Indirect costs are those which can only be indirectly
attributed to the manufacture of a specific product.
✓ Generally speaking these are costs other than the direct

costs associated with the manufacturing process.
✓ These can include costs for indirect materials, indirect

labor and indirect expenses.
9/3/2022 25
Table 2- Examples of indirect costs
9/3/2022 26
Job/Batch Costing
➢ This approach to costing is used where products are made
as individual job lots or in batches.
➢ This is typical of small-scale manufacturing and also

building, printing and other service industries where jobs
are done in response to customer orders.
9/3/2022 27
Job/Batch Costing Contd.
1. Prime costs
➢ The sum of the direct costs is known as the prime costs.
➢ All costs otherthan the prime costs are indirect costs.
➢ The prime costs can be calculated from the following:
Prime costs = Direct labor + Direct material + Direct

expenses
9/3/2022 28
Example 3
For the driveshaft manufactured in Examples 1 and 2, there
is additional direct expense of 560 Birr allocated for
special tooling.
Calculate the prime cost using the other direct costs

previously calculated.
9/3/2022 29
Solution
➢ Direct labor cost = 3119.50 Birr
➢ Direct material costs = 2505.00 Birr
➢ Other direct expense = 560.00 Birr
Prime costs = Direct labor + Direct material + Direct expenses

= (3112.5 + 2505.00 + 560)
= 6177.50 Birr
9/3/2022 30
2. Production Costs
➢ The prime costs deal solely with the direct costs incurred
through production of a specific product.
➢ Indirect costs for production and these are known as
production overheads.
➢ The production cost must be the sum of both prime costs &
production overheads as:
Production cost = Prime cost + Production overheads
9/3/2022 31
Example 4
Using the prime cost from Example 3 (6177.50 Birr),
Calculate the production cost given the following

information.
➢ Production office salaries- 3450.00 Birr
➢ Production area heating- 1243.00 Birr
➢ Production area lighting- 1046.00 Birr
9/3/2022 32
Solution
Production overheads 3450 Birr + 1243Birr + 1046 Birr =
5739 Birr
Production costs = Prime costs + Production overheads
= 6177.50 Birr + 5739 Birr
= 11 916.50 Birr
9/3/2022 33
3. Total cost
➢ The total cost of manufacturing a specific product is the
sum of production cost & overheads
➢ Typically, these overheads are for:
➢ Marketing
➢ Administration
➢ Research and development and
➢ Any function that indirectly contributes to the design,
manufacture and selling of a product.
Total Cost = Production cost + All other overheads
9/3/2022 34
Example 5
Using the production cost from Example 4 (11, 916.50 Birr),
Calculate the total cost of producing the batch of 1500
drive shafts given the following apportioned overheads:
➢ Marketing overheads 5,360 Birr

➢ Administration overheads 2,085 Birr
➢ R&D overheads 4,470 Birr
9/3/2022 35
Solution
➢ Total overheads = Marketing + Admin.+ R&D
= 5360 +2085 + 4470
= 11,915 Birr
➢ Total cost = Production cost + Total overheads
= 11,916.50 + 11,915
= 23,831.50 Birr
9/3/2022 36
4. Unit cost
➢ One further cost that is of interest in manufacturing is that
of the unit cost or the cost per unit.
➢ The unit cost is the cost for a finished product. Average

cost of manufacturing.
➢ This is generally found by taking the total cost of

production and dividing it by the number of units
produced, that is,
Unit cost = Total cost / Number of units
9/3/2022 37
Example 6
For the batch of drive shafts produced in Example 5,
 Calculate the unit cost
Solution
Total cost = 23,831.50 Birr
Number of units = 1500
Unit cost = Total cost/Number of units
= 23,831.50/1500 = 15.89 Birr
9/3/2022 38
5. Profit
➢ The aim of manufacturing organizations is to create a
profit from processing materials and adding value to
them and ultimately selling them at more than it cost to
process them.
➢ The profit is ultimately the difference between the selling

price and the total cost, that is,
Profit = Selling Price - Total Cost
9/3/2022 39
Example 7
➢ For the batch of drive shafts produced in Example 5, a
selling price of 27,000 Birr was agreed with the
customer when negotiating the contract.
 Calculate the profit made on the batch.
9/3/2022 40
Solution
➢ Total cost = 23,831.50 Birr
➢ Selling price = 27, 000.00 Birr
➢ Profit = Selling price - Total cost
= 27,000 Birr – 23,831.50 Birr
= 3,168.50 Birr
9/3/2022 41
Manufacturing Materials and Costs
➢ Material selection is not only considers appropriate
properties that allow it to perform satisfactorily during
service, but also considers the positive responses during
manufacture.
➢ The materials selection decision will generally be a

compromise between performance and cost.
9/3/2022 42
Manufacturing Materials And Costs Contd.
➢ The selection of a particular material will limit the

manufacturing options available and thus influence the
manufacturing cost.
➢ This can also have an influence on the basic material cost

in terms of the cost and energy required processing the
raw material into a useful material form for manufacture.
9/3/2022 43
Manufacturing Materials And Costs Contd.
➢ Another factor that determine the cost of material is
shape or form of the material.
➢ In solid form, most materials will be available as bar,
sheet and plate.
➢ For example, consider the relative cost of brass
(compared to mild steel=1) in bar, sheet and plate
form.
➢ Considering the cost per kilogram, it is cheapest in
sheet form with a relative cost of 3.67 and slightly
more expensive in plate form at 3.89, but higher
relative cost of 6.63 in bar form.
9/3/2022 44
Manufacturing Materials and Costs Contd.
➢ The use of relative costs based on either cost per kilogram

or cost per cubic meter allows the approximate relative
cost increase or decrease to be estimated when changing
from one material, or material form to another for a
particular product.
➢ Actual costs of material will fluctuate and the relative

cost ratio will remain fairly constant.
9/3/2022 45
Table 3- Relative costs for bar stock
9/3/2022 46
Table 4- Relative costs for sheet and plate stock
9/3/2022 47
Table 5- Relative costs for castings
9/3/2022 48
Example 8
In a bid to reduce the overall weight of an assembly, a cast
component has come under scrutiny.
 What will the relative cost change be if the material is

changed from cast iron to aluminum?
9/3/2022 49
Solution
➢ Relative cost of cast iron = 10
➢ Relative cost of aluminum = 16.75
➢ Cost increase = 16.75/10
= 1.675
 The material cost of the component will increase by
1.675
9/3/2022 50
Manufacturing Processes and Costs
➢ Just as competing manufacturing materials, cost
comparison is required between competing manufacturing
processes.
➢ A simple method for doing this comparison is a

combination of two approaches known as:
✓ Production cost formula and

✓ Break-even analysis
9/3/2022 51
Manufacturing Processes and Costs Contd.
1. Relative Surface Finish Costs
➢ When costing products, the cost of a component will

depend as much on the method of manufacture as the
material it is made from.
➢ Each process has an inherent ability to produce to within

certain limits of dimensional and geometric accuracy and
surface finish.
9/3/2022 52
Figure 3- Surface finishes for some common manufacturing processes
9/3/2022 53
Figure 4- Surface finish and relative cost
9/3/2022 54
Example 9
Preman Ltd are a sub-contracting firm & have been
instructed by a customer to improve the surface finish of a
turned part, which they are producing with finish turning,
from 1.6 to 0.4µm.
Determine the relative increase in cost of changing the

surface finish and determine if finish turning is still suitable.
✓If not, suggest an alternative.
9/3/2022 55
Solution
➢ Relative cost of 1.6µm surface finish = 5.5
➢ Relative cost of 0.4µm surface finish = 8.5
➢ Cost increase = 8.5/5.5
= 1.5
Note: Turning is suitable for surface roughness of 0.4µm as
it is capable of surface roughness value ranging between
0.2 to 6.3 µm
9/3/2022 56
➢ From the above it is clear that care must be taken in:

➢ Selecting an appropriate manufacturing process for the
given material and required surface finish.
➢ Specifying surface finish requirements.
➢ Both have the biggest influence on manufacturing costs.
9/3/2022 57
2. Production cost formula
➢ The production cost formula provides a simple method for
cost comparison between competing processes.
➢ Production cost is usually calculated as the sum of the
prime cost and the production overheads & may also be
expressed by the formula:
Where,
T is the total unit cost of manufacture of component, C the
set-up cost, Q the batch size & U the unit cost of manufacture
(direct labor + direct material per unit).
9/3/2022 58
Example 10
A large computer manufacturer requires 1200 printed circuit
board (PCB) carriers every month for the production of the
PCBs themselves.
Within their tool room, they have a variety of machining

processes available and the carriers are produced on a
conventional milling machine.
9/3/2022 59
The following information relates to the PCB carrier

manufacture:
✓ Set-up time ----------- 1 h 20 min
✓ Machining time ---------- 39 min
✓ Material cost/unit ---------- 5.62 Birr
✓ Machinist’s hourly rate --------- 9.85 Birr/Hr
9/3/2022 60
Solution
✓ Set-up cost C = 1 h 20 min @ 9.85 Birr= 13.13 Birr
✓ Labor cost/unit 9.85 Birr(39/60) = 6.40 Birr
✓ Material cost/unit = 5.62 Birr
✓ Unit cost, U = 12.02 Birr
 Take the batch size (Q) = 1200

➢ T = (13.13/1200) + (6.40+5.62)
➢ T = 12.03birr
9/3/2022 61
3. Break-even Analysis
➢The simplest and clearest way of relating cost, volume
and profit is through the use of a break- even chart.
Figure 6- Break-even chart

9/3/2022 62
➢ Break-even Analysis is used to demonstrate for a
particular product, with associated fixed and variable
costs, that a certain number of products must be sold
before a profit is made.
➢ The chart plots costs and expected income against

quantity produced.
➢ It can be described, in relation to labeled lines and

points, as follows:
9/3/2022 63
➢ AB– this represents the fixed costs which are unaffected
by production volume.
➢ BF– this represents the variable costs associated with

production volume.
➢ AE– this represents the variation in income against sales

volume.
➢ The assumption is that everything produced is sold.

9/3/2022 64
➢C – this is the point at which break-even is achieved, that

is, Sales Income = Total cost, and is known as the break-
even point.
➢ D– extrapolating down from point C to the x-axis gives

the quantity at which break-even is achieved, that is, the
break-even quantity.
9/3/2022 65
➢ The production of parts before point C results in a loss,
that is, the shaded area.
➢ Any parts produced after point C results in a profit.
➢ The use of break even is best illustrated by a worked
example.
➢ The break-even quantity can also be calculated using the
fixed costs, variable costs and selling price as follows:
9/3/2022 66
Example 11
Determine the break-even quantity using the following
information:
The variable cost is 47.00 Birr, the fixed costs are

32,000 Birr per period and the selling price is 155.00
Birr.
Solution
Break-even quantity= Fixed costs/(Selling price-Variable
costs)
= 32, 000/(155- 47) = 297
9/3/2022 67
4. Detailed Cost Comparison
➢ The profitability of a product is particularly affected

by the amount manufactured and can be investigated
by comparing costs incurred against income expected
using a break-even chart.
➢ The break-even chart can also be used to compare the

cost of two or more production methods for a given
product.
9/3/2022 68
Consider the bush shown in Figure 7 below.

✓This could be producedon either a center lathe or a CNC
lathe.
Figure 7- Brass bush

9/3/2022 69
➢ This could be represented on a break-even chart as
illustrated in Figure 8.
➢ As would be expected, the fixed costs for the center
lathe will be less than that of the CNC lathe.
➢ These will be based on the machine set-up costs CA and
CB respectively.
➢ However, the variable costs are less for the CNC machine
than for the center lathe and this is indicated by the
gradient of the lines UA and UB.
➢ These are typically based on the direct labor and
materials.
9/3/2022 70
➢ These can be stated in the format of the
production cost formula.
✓ For the center lathe:
✓ For the CNC lathe:
Figure 8- Break-even chart for cost comparison

9/3/2022 71
➢ Referring to Figure 8, the cost break-even point is
reached when the lines cross at the quantity QAB.
➢ Below this quantity, it is cheaper to produce on the center

lathe.
➢ However, above this quantity it is more cost effective to
use the CNC lathe.
➢ The break-even point occurs when:
9/3/2022 72
➢ In other words, the break-even quantity is calculated by

dividing the difference in set-up costs by the difference in
unit costs.
➢ This type of approach can be used for selecting between

various methods of fabricating, casting, molding, etc.
➢ It can also be used to choose between various categories

of manufacturing processes, as is illustrated in Example
12.
9/3/2022 73
Example 12
➢ The PCB carrier from Example 10 is usually made on a

conventional milling machine.
➢ However, it has been decided to investigate if there is any
significant cost advantage of producing these on a CNC
milling machine.
➢ Determine which machine is the most suitable for
producing the PCB carriers at the current rate of 1200
per month.
9/3/2022 74
Solution
➢ Method (a): Conventional milling machine
✓ Set-up time 1hr 20 min
✓ Machining time 39 min
✓ Material cost/unit 5.62 Birr
✓ Machinist’s hourly rate 9.85 Birr/Hr.
✓ Set-up cost C = 1hr 20 min @ 9.85 Birr
= 13.13 Birr
9/3/2022 75
 Take the batch size Q =1200

 Labor cost/unit = 9.85 Birr (39/60)
= 6.40 Birr
➢ Material cost/unit = 5.62 Birr
➢ Unit cost U = 12.02 Birr
Take the batch size Q=1200 Birr
T = (13.13 Birr/1200) + 12.02 birr

T = 12.03 Birr
9/3/2022 76
➢ Method (b): CNC milling machine
✓ Set-up time = 2hr & 55min
✓ Machining time 28min
✓ Material cost/unit = 5.62 Birr
✓ Machinist’s hourly rate 10.85 Birr/hr
✓ Set-up cost CB = 2hr & 55 min @ 10.85 Birr
= 31.65 Birr
9/3/2022 77
✓ Labor cost/unit = 12.85 Birr x (28/60)
= 5.06 Birr
✓ Unit cost UB = 10.68 Birr
✓ Take the batch size Q = 1200
9/3/2022 78
TB = (31.65/1200) + 10.68
= 10.706 Birr
Break-even analysis
QAB = (31.65 – 13.13) Birr/(12.02- 10.706) Birr

= 13
9/3/2022 79
➢ The quantity of PCB carriers at which it becomes

economical to produce them on a CNC milling machine, as
opposed to producing them on a conventional milling
machine, is 13.
This can also be represented graphically
✓ As a break-even chart as shown in Figure 9.
✓ Although it is not to scale.
9/3/2022 80
14,437.13 Birr*
12,847.64 Birr*
CB = 31.6458
CA = 13.13
13
9/3/2022
Figure 9- Cost comparison represented on a break-even chart 81
End of chapter five!!!
2/5/2021 82

L5 - Types of Costs and Cost Estimation of A Product

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College of Engineering

Department of Mechanical Engineering

Process planning & product costing (MEng 5322)

 Understanding costs in manufacturing &

➢ Based on the model of added value, the manufacturing

1. Control– to help control the manufacturing system

➢The manufacturing engineer carries out a cost

3. Reporting and recording- involves the compilation and

❖Various costs contribute towards the selling price of a

➢ Overheads (typically marketing, sales, customer service

➢ The profit margin

 Manufacturing costs are shown below with typical

Figure 1- Cost elements of product selling price.

Figure 2- Elements of manufacturing costs.

➢ Throughout the analysis procedure, the planner will

➢ These estimates must be made to allow management to

➢ The accuracy of the process plan will have a major

If the estimate is too low, the company will end up

➢Variable costs– related directly to the quantity

✓ Examples- are occupancy and financing costs,

➢ Depreciation is a charge made for the value of plant used

➢ Fixed costs are also termed as indirect costs.

Table 1- Typical fixed and variable costs

✓ Direct material costs;

✓ Any other expense that can be directly attributed to

➢ This cost can be found by multiplying the direct workers’

➢ This can be calculated by multiplying the material cost per

Direct material cost = Material cost/unit*Number of units

 Calculate the direct material costs.

✓ Generally speaking these are costs other than the direct

✓ These can include costs for indirect materials, indirect

➢ This is typical of small-scale manufacturing and also

➢ All costs otherthan the prime costs are indirect costs.

➢ The prime costs can be calculated from the following:

Prime costs = Direct labor + Direct material + Direct

Calculate the prime cost using the other direct costs

Prime costs = Direct labor + Direct material + Direct expenses

Production cost = Prime cost + Production overheads

Calculate the production cost given the following

➢ Marketing overheads 5,360 Birr

➢ The unit cost is the cost for a finished product. Average

➢ This is generally found by taking the total cost of

 Calculate the unit cost

➢ The profit is ultimately the difference between the selling

Profit = Selling Price - Total Cost

 Calculate the profit made on the batch.

➢ The materials selection decision will generally be a

➢ The selection of a particular material will limit the

➢ This can also have an influence on the basic material cost

➢ The use of relative costs based on either cost per kilogram

➢ Actual costs of material will fluctuate and the relative

 What will the relative cost change be if the material is

➢ A simple method for doing this comparison is a

✓ Production cost formula and

➢ When costing products, the cost of a component will

➢ Each process has an inherent ability to produce to within

Determine the relative increase in cost of changing the

✓If not, suggest an alternative.

➢ From the above it is clear that care must be taken in:

➢ Specifying surface finish requirements.

➢ Both have the biggest influence on manufacturing costs.

Within their tool room, they have a variety of machining

The following information relates to the PCB carrier