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Lecture 2

Costs
Engineering Costs, Estimation Models &
Cash flow Diagram

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Learning Objectives
 Understand various cost concepts
 Breakeven charts
 Understand various cost estimation
models
 Be able to estimate engineering costs with
various models
 Cash Flow Diagrams
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Engineering Costs & Cost Estimating
Key Question: Where do the numbers come from that we use in
engineering economic analysis?

• Cost estimating is necessary in an economic analysis

• When working in industry, you may need to consult with


professional accountants, engineers and other specialists
to obtain such information

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Cost Terminologies
Cost is the “price paid by the user of scare economic resources to the
provider of the resources”. The study of engineering economics involves
many costs as evaluating a set of feasible alternatives requires that
many costs be analyzed.

 On the Basis of Service Period


 Short Run Cost
 Long Run Cost

 On the Basis of Cost Behavior to Production Volume:


 Fixed cost
 Variable cost

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Cost Terminologies Cntd…
 On the basis of changes in total costs in relation to certain specified
volume :
 Total cost
 Average cost
 Marginal cost

 Some other important classification of costs:


 Opportunity cost & Sunk cost
 Recurring and Non Recurring Costs
 Book Cost & Cash Cost
 Life Cycle Cost

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Short Run & Long Run Costs
The Short-run costs have a short-term service period, usually up
to one year. Costs incurred on materials, operating expenses like
cost of labor and utilities like power, water they are known as
short term cost.

The long-run costs are those cost whose benefits period extend
for several future year. Purchase of fixed assets like land, building,
machines, furniture, vehicles etc. Cost incurred on research and
development and training to employees are treated as long-term

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Engineering Costs
Fixed costs
 The costs that do not change during the time horizon of the
study. They may relate to the constant costs of equipment,
utilities, rent, etc.

 Constant, independent of the output or activity level.

 Examples:
 Property taxes, insurance
 Management and administrative salaries
 License fees, and interest costs on borrowed capital
 Rental or lease
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Example
A manufacturing plant that assembles television sets has
variable output volume from 200 sets to 350 sets a day.
The building for both manufacturing and warehousing has
an area of 80, 000 square feet. It employs about 250
people. It produces all of the components that go into the
assembly.
An example for fixed cost in this plant is ------------------
A) Equipment Cost
B) Power cost Equipment cost stays the same
regardless the level of output once
C) Labor Cost the plant has been designed to
produce at a certain level.
D) Material Cost

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Engineering Costs
Variable costs
 Costs that vary during the time horizon of the study &
Over the long-term all costs are variable.

 Depends on the level of output or activity.

 Proportional to the output or activity level.


 Example:
 Direct labor cost
 Direct materials

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Example
A manufacturing plant that assembles television sets has
variable output volume from 200 sets to 350 sets a day.
The building for both manufacturing and warehousing has
an area of 80, 000 square feet. It employs about 250
people. It produces all of the components that go into the
assembly.
An example for variable cost in the plant is ---------------.
A) Building cost
B) Equipment Cost
C) Labor Cost Labor cost depends on the output level
D) Property Taxes
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Relevant Formulae
 Total Variable Cost = Unit Variable Cost * Quantity
 TVC = VC * Q
 Total Cost = Total Fixed Cost + Total Variable Cost
 TC = FC + VC * Q
 Total Revenue = Unit Selling Price * Quantity
 TR = SP * Q
where TVC = Total variable cost
VC = Variable cost per unit
Q = Production/Selling quantity
FC = Total Fixed costs
TR = Total revenue
SP = Selling price per unit
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Example
A company produces a single, high-volume product. One
year its production volume was 780,000 units, its fixed
costs were $3.2 million and its variable costs were $16 per
unit. What was the company's total cost for the year?
A) $3,200,000
B) $3,200,016 TVC = 780,000 x 16 = $12,480,000
C) $12,480,000 FC = $3.2M

D) $15,680,000 TC = FC+TVC = $15,680,000

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Profit and Loss Terms
 In terms of costs and revenues there are three possible profit
and loss points for a business activity.

Refer to Lecture 1: Equilibrium & Disequilibrium

 Breakeven: total revenue = total costs


 Just getting along
 Profit region: total revenue > total costs
 Putting money in the bank
 Loss region: total revenue < total costs
 Going into debt
Breakeven Analysis
Breakeven point: The level of business activity at which the
total costs to provide the products (goods), or services are
equal to the revenue generated. That is:

Total costs = Total revenue


Total costs = Total fixed costs + Total variable costs

•Applications of Breakeven analysis:


– Determining minimum production quantity
– Forecast production profit / loss

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Breakeven Analysis
Total Revenue
$

Profit Total Costs

Variable Costs

Fixed Costs
Loss

Break-even Point Production Quantity

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Example
A manufacturing firm’s specialty circuit board division has
annual fixed costs of $100,000
and variable costs of $20.00 per board.
If they charge $100 per circuit board, how many circuit
boards must they produce and sell in order to break even?

To break even, total costs = total revenue,


where total costs = total fixed costs + total variable costs.
$100,000 + $20X = $100X
X = $100,000/$80 = 1250 circuit boards.

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Example
In breakeven analysis, the profit at the breakeven point is
equal to

A) The total cost The total revenue is equal to the total cost.
Therefore…
B) Zero
C) The total revenue
D) The variable cost multiplied by the number of items sold

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Marginal Costs & Average Costs
 Marginal Costs : defined as the change in total costs with one unit
increase or decrease in the current quantity produced. It is used to
decide whether an additional unit should be made, purchased, or
enrolled in.
 the variable cost for one more unit of output
 Capacity Planning: excess capacity
 Basis for last-minute pricing
ΔTC
ΔQ
 Average Costs: It indicates the per unit cost at different level of
production activities. Because of the fixed element of the TFC, the
average cost per unit decreases as the production increases.
ATC = TC
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x
Example
What is marginal cost? Explain with an
example.
 the cost of producing one additional unit.
 used for making a decision of whether or not it is economical to produce
another unit of the same item.

 For example, the total cost of producing one pen is $5 and the total cost of
producing two pens is $9, then the marginal cost of expanding output by
one unit is $4 only (9 - 5 = 4).

 The marginal cost of the second unit is the difference between the total cost
of the second unit and total cost of the first unit. The marginal cost of the
5th unit is $5. It is the difference between the total cost of the 6th unit and
the total cost of the, 5th unit and so forth.
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Albert’s Charter Bus Venture
(example)
Albert plans to charter a bus to take people to see a wrestling match
show in Jacksonville. His wealthy uncle will reimburse him for his
personal time, so his time cost can be ignored.

Item Cost Item Cost


Bus Rental $80 Ticket $12.50
Gas Expense $75 Refreshments $ 7.50
Other Fuel Costs $20
Bus Driver $50

Total Costs $225.00 Total Costs $20.00

• Which of the above are fixed and which are variable costs?
• How do we compute Albert’s total cost if he takes n people to Jacksonville?

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Albert’s Charter Bus Venture (example)
 Answer: Total Cost = $225 + $20 n.
Graph of Total Cost Equation:

Total cost

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marginal cost
-The cost to take one more person
Marginal and Average Costs
average cost
- Average cost: the cost per person
$300.00

Avg.$250.00
Cost = TC/n
Avg.$200.00
Cost = ($225+$20n)/n
= $20 + $225/n Average
Cost

$150.00 Marginal
Trip Ticket
 For n = 30, TC = $885
$100.00
Marginal and Average Costs

Avg. Cost = $885/30 = $29.50 $300.00

$50.00 $250.00

$200.00
$0.00 Average
Cost

$150.00 Marginal
1 3 5 7 9 11 13 15 17 19 21 23 Trip Ticket
$100.00
Number of People
$50.00

$0.00
1 3 5 7 9 11 13 15 17 19 21 23
Number of People

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Question: Do we have enough information yet to decide
how much money Albert will make on his venture? What
else must we know?
 Albert needs to know his total revenue
 Albert knows that similar ventures in the past have charged
$35 per person, so that is what he decides to charge
 Total Revenue = 35n (for n people)
Total profit =
Total Revenue – Total Cost:
35n – (225 + 20n) = 15n – 225
Question:
How many people does Albert need to break even?
(not lose money on his venture)

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Albert's Charter Bus Venture
Question:
How many people does Albert need to break even?
$1,000.00

(not lose money on his venture)


$800.00

Solve$600.00
15 n – 225 = 0 => n=15
more$400.00
than 15, he makes money
Total Cost

Cost
Revenue
$200.00 Profit

$0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
($200.00)

($400.00)
Number of People

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Albert’s Charter Bus Venture
(example)
Where is the Loss Region?
Where is the Profit Region?
Where is the Breakeven point?

Albert's Charter Bus Venture

$1,000.00

$800.00

$600.00
Total Cost

$400.00 Cost
Revenue
$200.00 Profit

$0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
($200.00)

($400.00)
Number of People

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Example 2-1
Total Revenue
$1000 = 35X

Profit Total Costs


$800 = $225 + 20X

Variable Costs
$600 = 20X

$400

Fixed Costs
$200 Loss = $225

X
$0
5 10 15 20 25 # of Customers

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Exercise 2.3
A new machine comes with 100 free service hours over the
first year. Additional time costs $75 per hour. What are the
average and marginal costs per hour for the following
quantities?
a) 75 hours

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Exercise 2.3
A new machine comes with 100 free service hours over the
first year. Additional time costs $75 per hour. What are the
average and marginal costs per hour for the following
quantities?
b) 125 hours

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Exercise 2.3
A new machine comes with 100 free service hours over
the first year. Additional time costs $75 per hour. What are
the average and marginal costs per hour for the following
quantities?
c) 250 hours

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Exercise 2.7
A privately owned summer camp for youngsters has the following data for a
12-week session:
 Charge per camper $120 per week
 Fixed costs $48,000 per session
 Variable cost per camper $80 per week
 Capacity 200 campers

a) Develop the mathematical relationships for total cost and total revenue.

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Exercise 2.7
A privately owned summer camp for youngsters has the
following data for a 12-week session:
 Charge per camper $120 per week
 Fixed costs $48,000 per session
 Variable cost per camper $80 per week
 Capacity 200 campers
b) What is the total number of campers that will allow the camp to
just break even?

$48,000 = $480 x

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Exercise 2.7
A privately owned summer camp for youngsters has the
following data for a 12-week session:
 Charge per camper $120 per week
 Fixed costs $48,000 per session
 Variable cost per camper $80 per week
 Capacity 200 campers
c) What is the profit or loss for the 12-week session if the camp
operates at 80% capacity

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Exercise 2.7
A privately owned summer camp for youngsters has the
following data for a 12-week session:
 Charge per camper $120 per week
 Fixed costs $48,000 per session
 Variable cost per camper $80 per week
 Capacity 200 campers
d) What are marginal and average costs per camper at
80% capacity?
x = 160
Marginal cost is the slope of the equation which is
equal to $960
Average cost is Total Cost/x
= ($48,000 + $960 * 160)/160 = $1260
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Sunk Costs
 Costs associated with decisions already made.

 Money already spent as a result of a past decision.

 Cost that has occurred in the past and has no


relevance to estimates of future costs and revenues
related to an alternative

 Must be ignored because current decisions can not


change the past
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Sunk Costs
A sunk cost is money already spent due to a past decision.

 As engineering economists we deal with


present and future opportunities

 We must be careful not to be influenced by the past

 Disregard sunk costs in engineering economic analysis

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Sunk Costs
Example:
Suppose that three years ago your parents bought you a
laptop PC for $2000.
 How likely is it that you can sell it today for what it cost?
 Suppose you can sell the laptop today for $400. Does the
$2000 purchase cost have any effect on the selling price
today?

The $2000 is a sunk cost. It has no influence on the present


opportunity to sell the laptop for $400. ( stock now costs $20
but you bought for $80)

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Example
All of the following are usually included in an engineering
economic analysis except
A) Fixed costs

B) Variable costs

C) Sunk costs

D) Total revenue

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Opportunity Costs
 Using a resource in one activity instead of another

 Cost of the foregone opportunity which is hidden or


implied

 Going for $3000 trip and miss the opportunity of earning


$5000 in summer internship

 Buying lunch instead of gas

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Sunk and Opportunity Cost-1
Example 2-3. A distributor of electric pumps must decide what
to do with a "lot" of old electric pumps that was purchased 3
years ago. Soon after the Distributor purchased the lot,
technology advances were made. These advances made the old
pumps less desirable to customers. The pumps are becoming
more obsolescent as they sit in inventory. The pricing manager
has the following information.

Item Amount Type of Costs


Price for case 3 years ago $7,000 Sunk cost
Storage costs to date $1,000 Sunk cost

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Sunk and Opportunity Cost-2
Example 2-3. (cont.)
Item Amount Type of Costs

List price today for a case of Can be used to help


new and up to date pumps $12,000 determine what the lot is
worth today.
Amount buyer offered for case
2 years ago $5,000 A foregone opportunity

Case can currently be sold for $3,000 Actual market value today

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IMPLICIT AND EXPLICIT COST
The implicit cost are also consider in terms
 The explicit cost is certain and fixed
E.g.. 10% interest on bond.

 The implicit cost are also consider in terms of incidental events or cost
of inconvenience. al events or cost of
inconvenience.
Recurring Costs and Non-recurring Costs
 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, even though the total


expenditure may be cumulative over a period of time
 Typically involves developing or establishing a capability or
capacity to operate
 Examples are purchase cost for real estate and the
construction costs of the plant

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Incremental Costs
 Incremental Costs: Difference in costs between two
alternatives.

 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 (B - A) is $4,000.

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Example 2-3
Choosing between Model A & B
Cost Items Model A Model B Incremental Cost

Purchase Price $10,000 $17,500 $7,500

Installation Costs $3,500 $5,000 $1,500

Annual Maintenance * $2,500 $750 $ -1,750/yr

Annual Utility * $1,200 $2,000 $800/yr

Disposal Cost $700 $500 $ -200

* Must be multiplied by the number of years of service.


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Incremental Vs Opportunity Cost
Example
 incremental costs are those costs that change depending on
which alternative you choose. Suppose you want to buy a new
bicycle. Incremental costs of buying the bike include the actual
price of the bike plus any accessories. You also need to pay for
gas and tolls to drive to and from the bike store — another
incremental cost.

 On the other hand, the cost of buying lunch after purchasing the
bike isn’t an incremental cost because you need to pay for that
regardless of whether you buy the bike

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Cash Costs versus Book Costs
Book Costs:
 Costs that do not involve money/cash transaction
 Cost effects from past decisions that are recorded in the books
(accounting books) of a firm
 Do not represent cash flows
 Not included in engineering economic analysis
 One exception is for asset depreciation or for future cost
prediction.
 Depreciation Example:
 Depreciation is charged for the use of assets, such as plant
and equipment—This is used to determine the value of the
company and in computing taxes.
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Cash Costs versus Book Costs
Cash Costs:
 Costs that involve money/cash transaction
 Require the cash transaction of dollars from “one pocket to
another”.
 Example:
 Interest payments, taxes, etc.
 You know from an xyz book that the book value of your car is
$6,000. The book value can be thought of as the book cost.
If you actually sell the car to a friend for $5,500, then the
cash cost to your friend is $5,500.

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Life-Cycle Costs
 Life-cycle - all the time from the initial conception of an
idea to the death of a product (process).

 Life-cycle costs - sum total of all the costs incurred during


the life cycle (Recurring & Non Recurring)

 Life-cycle costing - designing a product with an


understanding of all the costs associated with a product
during it’s life-cycle.

 LCCA: Fixed + Variable+Direct+Overhaul+Indirect= 48


4 Stages of Product Life Cycle
WOMB – TOMB

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Phases of Life Cycle
1. Need 2.Conceptual 3. Detailed 4. Production 5.Operational 6. Decline/
Assessment Design Design /Construction Use Retirement
Requirements Impact Allocation of Production of Distribution of Phase Out
Analysis Analysis Resources Goods/ Goods/
Services Services
Overall Proof of Detailed Building of Maintenance/ Disposal
Feasibility Concept Specifications Supporting Support
Study Facilities
Conceptual Prototype/ Component/ Quality Retirement Retirement
Design Breadboard Supplier Control/ Planning
Planning Selection Assurance
Development/ Production Operational
Testing Planning Planning
Detailed
Design
Planning

Cradle to grave- womb to tomb 50


Cumulative Life-Cycle Costs
Committed and Spent
100%
90%
80%
70%
Life-Cycle Costs Committed
60%
50%
40% Life-Cycle Costs Spent

30%
20%
10%
0%
Need Conceptual Detailed Production Operational Decline/
Assessment Design Design /Construction /Use Retirement

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Cost/Ease of Design Changes
in
Product Life Cycle
100%
90% Ease of Design Changes
80%
70%
60% Cost of Design Changes
50%
40%
30%
20%
10%
0%
Need Conceptual Detailed Production Operational Decline/
Assessment Design Design /Construction /Use Retirement

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Summary
This chapter introduced the cost concepts: fixed and variable,
marginal and average, sunk, opportunity, recurring and
nonrecurring, incremental, cash and book, and lifecycle.

Fixed costs are constant and unchanging as volumes change,


while variable costs change as output changes.

Fixed and variable costs are used to find the breakeven value
between costs and revenues, as well as the regions of net profit
and loss.

A marginal cost is for one more unit, while the average cost is the
total cost divided by the number of units.
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End of Chapter 2