EUT 444 : Pengurusan Kejuruteraan /

Engineering Management

Cost Concepts And Design Economics

analyzing short-term alternatives when the time value of
money is not a factor

1-1
Engineering decision which based on economy (money)
criteria

Profit = Revenue - Cost

1-2
 Contents
• Basic Terminology of Cost and Revenue
• Law of Supply and Demand
• Cost, Production Volume, and Breakeven Point
Relationships
• Economic Breakeven Point
• Point of Maximum Profit
• Cost Estimation Techniques
1-3
1.0 Cost Terminology
An amount that has to be paid or given up in order to get or
produce something.
Generally, cost is usually a monetary valuation of;
• Effort • Material
• Resources • Time and utilities consumed
• Risks incurred
• Missing or forgone opportunity

1-4
1.1 Accounting Cost (Book) versus Analytical
Cost (Cash)
Accounting cost is a cost which does not involve a cash transaction and is
reflected in the accounting system, such as an anticipated saving due to certain
proactive measures taken in product manufacturing or the opportunity lose.
• Opportunity Cost and Actual Cost
• Explicit Cost and Implicit Cost

Analytical cost is a cost that involves payment of cash (and results in a cash
flow)
• Fixed and Variable Cost
• Total, Average and Marginal Costs
• Incremental and Sunk Costs
1.2 Fixed And Variable 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 capital cost, general management and
administrative salaries, license fees, and interest costs on borrowed capital.
The cost you have to pay when you produce nothing

Variable costs are those associated with an operation that vary in total with the
quantity of output or other measures of activity level (operating cost).
Example of variable costs include : costs of material and labour used in a
product or service, because they vary in total with the number of output units --
even though costs per unit remain the same.
FIXED + VARIABLE COST = TOTAL COST
 𝐹𝐶+𝑉𝐶=𝑇𝐶

1-7
 Short Run Production/Output
Cost
TC

TVC
Optimum output level
TFC

Quantity of Output
1.3 Incremental (Marginal) Cost / Revenue
Incremental Cost = the additional cost (or revenue) that results from increasing
the output of a system by one (or more) units.

Considered in long production run

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Example 1
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 (yd3-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):

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. 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?
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Solution
The fixed and variable costs for this job are indicated in the table shown next. Site rental,
setup, and removal costs (and the cost of the flagperson at Site B) would be constant for the
total job, but the hauling cost would vary in total amount with the distance and thus with the
total output quantity of yd3-miles (x).

Site B, which has the larger fixed costs, has the smaller total cost for the job. Note that the
extra fixed costs of Site B are being “traded off” for reduced variable costs at this site.

The contractor will begin to make a profit at the point where total revenue equals total cost as a
function of the cubic yards of asphalt pavement mix delivered. Based on Site B, we have;

3($2.75) = $8.25 in variable cost per yd3 delivered

Total cost (fixed cost + variable cost = total revenue)
$90,750 + $8.25x = $12x; Solving for x, x = 24,200 yd 3 delivered.

Therefore, by using Site B, the contractor will begin to make a profit on the job after delivering
24,200 cubic yards of material. How much is the profit?
1.4 Direct, Indirect, and Standard Costs
Direct costs are costs that can be reasonably measured and allocated to a specific
output or work activity. The labor and material costs directly associated with a
product, service, or construction activity are direct costs. For example, the
materials needed to make a pair of scissors would be a direct cost.

Indirect costs are costs that are difficult to allocate to a specific output or work
activity. Normally, they are costs allocated through a selected formula (such as
proportional to direct labor hours, direct labor dollars, or direct material dollars) to
the outputs or work activities. For example, the costs of common tools, general
supplies, and equipment maintenance in a plant are treated as indirect costs.

Direct cost examples
• Physical assets
• Maintenance and operating costs
(M&O)
• Materials
• Direct human labor (costs and
benefits)
• Scrapped and reworked product
• Direct supervision of personnel
Indirect cost examples
• Utilities
• IT systems and networks
• Purchasing
• Management
• Taxes
• Legal functions
• Warranty and guarantees
• Quality assurance
• Accounting functions
• Marketing and publicity
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 costs per unit).

Standard costs play an important role in cost control and other management
functions
1.5 Sunk Cost
Sunk Cost is one that has occurred in the past and cannot be recovered. It has no
relevance to estimates of future costs and revenues related to an alternative course
of action. Thus, a sunk cost is common to all alternatives, is not part of the future
(prospective) cash flows, and can be disregarded in an engineering economic
analysis. For instance, sunk costs are nonrefundable cash outlays, such as earnest
money on a house or money spent on a passport.
1.6 Life-Cycle Cost (LCC)
Life-cycle cost is the summation of all costs, both direct and
indirect, recurring and nonrecurring, related to a product,
infrastructure, system, or service during its life span.

Product life cycle begins with the identification of the economic

need or want (feasibility/market study, product specifications,
R&D activities) and ends with the retirement and disposal
activities.
1.6.1 Life-Cycle Cost Analysis Principle
Cost unaffected by the change in the
level of production activities ;
• Capital cost
• Management / admin salaries
Fixed Cost • Licence fees
• R&D • Interest on borrowed capital
• Init investment Recurring and
• Infrastructure Nonrecurring Cost 5 phases
• Design Product Life-Cycle • Development
• Manufacturing Cost • Introduction
• Testing • Growth
Direct and
• Depreciation
• Disposal
Indirect Cost • Maturity
Variable Cost • Decline

Cost that vary with the quantity of the

produced output;
Green technology requirement; • Raw materials
• Materials selection • Labor etc
• Eco-friendly processes
• Reusability, recycling
1.7 Total Cost, Average Cost And Marginal
Cost
Average Cost (cost to produce 1 unit of product)
= Total Cost / Total Number of Produced Unit
  𝑇𝐶
𝐴𝐶=
𝑄
Marginal Cost = the change in the Total Cost that arises when the quantity
produced is incremented by one unit, that is, it is the cost of producing one more
unit of a good
  Δ𝑇𝐶
𝑀𝐶=
Δ𝑄
Output Fixed Cost Variable Total Cost Marginal Av. Fixed Av. Var. Av. Cost
Q FC Cost, VC C Cost, MC Cost, Cost AC = TC/Q
AFC = AVC =
FC//Q VC/q
0 48 0 48
1 48 25 73 25 48 25 73
2 48 46 94 21 24 23 47
3 48 66 114 20 16 22 38
4 48 82 130 16 12 20.5 32.5
5 48 100 148 18 9.6 20 29.6
6 48 120 168 20 8 20 28
7 48 141 189 21 6.9 20.1 27
8 48 168 216 27 6 21 27
9 48 198 246 30 5.3 22 27.3
10 48 230 278 32 4.8 23 27.8
11 48 272 320 42 4.4 24.7 29.1

MC < AC : AC decreases MC = AC : AC at the minimum

MC > AC : AC increases
1.8 Total Revenue, Average Revenue And Marginal
Revenue
What is Revenue ?
Revenue – payment in terms of money which is received by the seller (or
company) from sale of product or services to the buyer (or consumer)

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Handbag Producer
Various model with different prices

No of bags sold Price of bag (RM) Total Revenue (RM)

1 20 20
1 30 50
1 40 90
1 50 140
1 60 200

Total revenue (TR) – Total money received from

the sale of all products
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No of bags sold Price of bag (RM) Total Revenue (RM)
1 20 20
1 30 50
1 40 90
5
1 50 140
1 60 200

Average revenue (AR) = TR / No of units sold

= 200 / 5 = 40

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No of bags sold Price of bag (RM) Total Revenue (RM)
1 20 20
Net addition to TR
1 30 50
= 50 – 20 = 30
1 40 90 = 90 – 50 = 40
1 50 140
1 60 200

Marginal revenue (MR) = Net addition to TR when one additional

unit is sold.
MR = Change in TR / change in quantity sold = ∆ TR / ∆Q

1-24
1.9 Relationship Between Total Revenue And Marginal
Revenue
Bag Total bag Price of Marginal Total revenue
sold sold bag revenue TR increases when MR is +ve
1 1 20 20 20 TR is maximum when MR is 0
1 2 25 25 45 TR decreases when MR is -ve
1 3 30 30 75
MR is positive
1 4 15 15 90
1 5 0 0 90 MR = 0
1 6 -10 -10 80 MR = -ve

Cost > selling price

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2.0 Law Of Supply and Demand
Economic Activity

money
Buyer revenue to the seller Seller

Product
 2.1 Law of Demand (Consumer)

Demand – Different quantities that people are willing and able to buy at
different prices.
b is the amount by which demand increases
for each unit decrease in p.
P Qd
for 0 ≤ D ≤ a/b
𝒑=𝒂
  −𝒃𝑫(𝟏)
P and a > 0, b > 0,
𝑎− 𝑝
 
𝐷=
𝑏
;𝑏≠ 0

P Qd
D (unit of Demand) Q
General Price–Demand Relationship.
There is another situation (economic model) where price is independent on demand.
2.2 Law of Supply (Producer)

Supply – Different quantities that firms are willing and able to produce at
different prices.

Qs P
P

Qs P S (quantity supplied) Q

Direct relationship between price and quantity supplied

2.3 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.
𝑇𝑅=
  𝑝𝑟𝑖𝑐𝑒 ×𝑑𝑒𝑚𝑎𝑛𝑑= 𝑝 . 𝐷(2)
for 0 ≤ D ≤ a/b
2
𝑇𝑅=
  ( 𝑎 − 𝑏𝐷 ) . 𝐷 =𝑎𝐷 −𝑏𝐷 (3) and a > 0, b > 0,
 Solving Eq (3) If we keep selling the same product

The demand, Ð that will produce maximum TR can be obtained by

solving;
 𝑑𝑇𝑅 =𝑎 −2 𝑏𝐷=0(4)
𝑑𝐷
Therefore;
𝑎
 Ð= (5)
2𝑏
Note : due to cost–volume relationships most businesses would not obtain maximum
profits by maximizing revenue (maximum TR) i.e Maximum revenue does not mean
maximum profit.
3.0 Cost, Volume, and Breakeven Point
Relationships
Revenue
RM110 (profit)
Producer Cost to produce product
RM100 Break even
RM90 (loss)

Break even point is the point when the total revenue earned by
a producer is equal to the total cost incurred by him.

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Unit of output Total revenue Total cost Profits
10 200 210 -10
20 240 245 -5
30
Unit of output 280
Total revenue Total cost280 profits 0 TR = TC (break even)
40
10 320
200 315
210 5
-10
20
50 240
360 245
340 -5
20
30
60 280
400 280
390 100
40 320 315
70 440 435 55

Break even occurs at 30 units of output

At any demand D, total cost is

 
With the assumption

 
Where Cv is variable cost per unit (TVC/quantity produced).
When TR function is combined with Eq (6) and (7).

TC

Total Revenue function

TFC

Breakeven Point (TR=TC)

• At Breakeven Point D′1 (TR=TC), an increase in demand will result in a profit for the
operation.
• At optimal demand, D∗, profit is maximized (TR-TC at the greatest amount).
• At breakeven point D′2, total revenue and total cost are again equal, but additional volume
will result in an operating loss instead of a profit
3.1 Point of Maximum Profit
Profit = total revenue (TR) − total costs (TC). other approach is when
MR = MC
From Equations (3), (6) and (7)
2
𝑃𝑟𝑜𝑓𝑖𝑡
  = ( 𝑎𝐷 − 𝑏𝐷 ) − ( TFC +𝐶 𝑣 𝐷 ) (8)
2
𝑃𝑟𝑜𝑓𝑖𝑡
  =− 𝑏 𝐷 + ( 𝑎 −𝐶 𝑣 ) 𝐷 − 𝑇𝐹𝐶 (9)
we can find the optimal demand (D* point) at which maximum
profit will occur by taking the first derivative of Eq(9) with respect
to D and setting it equal to zero: i.e. no additional profit when the
volume is increased.

 𝑑 ( 𝑝𝑟𝑜𝑓𝑖𝑡 ) = 𝑎 − 𝐶 𝑣 − 2 𝑏𝐷= 0(10)

𝑑𝐷
Therefore, the optimum value of D that maximizes profit is;
  𝐷 ∗ = 𝑎 − 𝐶 𝑣 ( 11 )
2𝑏
3.2 Economic Breakeven Point
Total revenue (TR) = Total costs (TC) (Breakeven Point)
From Equations (3), (6) and (7)

2
𝑎𝐷
  − 𝑏 𝐷 = 𝑇𝐹𝐶 +𝐶 𝑣 𝐷 (12)
2
−𝑏
  𝐷 + ( 𝑎 − 𝐶 𝑣 ) 𝐷 −𝑇𝐹𝐶 =0 (13)

Solving a quadratic equation yield;

′
 
𝐷 =− ( 𝑎 − 𝐶 𝑣 ) ± ¿ ¿ ¿
Example 2
A company produces an electronic timing switch that is used in consumer and commercial
products. The fixed cost (TFC) is $73,000 per month, and the variable cost (C v) is $83 per unit.
The selling price per unit is p = $180 − 0.02(D), based on Equation (1). For this situation,

(a) determine the optimal volume for this product and the profit earned at optimum production
level.

(b) find the volumes at which breakeven occurs; that is, what is the range of profitable
demand?

Solution
a) The optimal volume i.e production point with maximum profit is given by Equation (11)

 𝐷 ∗ = 𝑎 − 𝐶 𝑣 = 180 − 83 = 2,425 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡h .

2𝑏 2 (0.02 )

 
 

A demand of D∗ = 2,425 units per month results in a maximum profit of $44,612

per month.
A company produces an electronic timing switch that is used in consumer and commercial
products. The fixed cost (TFC) is $73,000 per month, and the variable cost (Cv) is $83 per
unit. The selling price per unit is p = $180 − 0.02(D), based on Equation (1). For this situation,

(b) find the volumes at which breakeven occurs; that is, what is the range of profitable
demand?

Solution
b) Total revenue = total cost (breakeven point) (13)
2
−𝑏
  𝐷 + ( 𝑎 − 𝐶 𝑣 ) 𝐷 −𝑇𝐹𝐶 =0
2
−0.02
  𝐷 + ( 180− 83 ) 𝐷− 73,000=0
2
−0.02
  𝐷 +97 𝐷 −73,000=0
′
 
𝐷 =− 97 ± ¿ ¿ ¿
 𝐷 ′ 1= − 97+59.74 =932𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡h
−0.04
 𝐷 ′ 2= − 97 −59.74 =3,918 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡h
− 0.04
Breakeven occurs at production point of 932 units per month.
While the range of profitable demand is 932–3,918 units per month.
4.0 Cost Estimation
Cost estimation is important in all aspects of a project, but especially in the stages
of project conception, preliminary design, detailed design, and economic analysis.
When a project is developed in the private or the public sector, questions about
costs and revenues will be posed by individuals representing many different
functions: management, engineering, construction, production, quality, finance,
safety, environmental, legal, and marketing, to name some.

In engineering practice, the estimation of costs receives much more attention

than revenue Estimation.
4.1 Purposes of Cost Estimation
1. Providing information used in setting a selling price for quoting, bidding, or
evaluating contracts

2. Determining whether a proposed product can be made and distributed at a

profit (for simplicity, price = cost + profit)

3. Evaluating how much capital can be justified for process changes or other
improvements

4. Establishing benchmarks for productivity improvement programs

4.2 Cost Estimation Aproach
Top-Down Approach – Based on historical data: costs, revenues, and other data
for the current project by modifying these data for changes in inflation or
deflation, activity level, weight, energy consumption, size, and other factors.

This approach is best used early in the estimating process when alternatives are
still being developed and refined.
Bottom Up Approach - A more detailed method of cost estimating. This method
breaks down a project into small, manageable units and estimates their economic
consequences. These smaller unit costs are added together with other types of
costs to obtain an overall cost estimate.

This approach usually works best when the detail concerning the desired output (a
product or a service) has been defined and clarified.
 Refer Example 3.1 in the textbook (Page 69) – example of top-down and
bottom up approach.

Integrated Approach– A more complete approach including WBS, classification

and comprehensive economical model (we do not cover in this course)
 4.3 Accuracy of Cost Estimates
General guidelines for accuracy
Conceptual/Feasibility stage – order-of-magnitude
estimates are in range of ±20% of actual costs
Detailed design stage - Detailed estimates are in
range of ±5% of actual costs

Characteristic curve of accuracy vs. time to make estimates

4.4 Cost Estimation Models
1. Cost Indexed

2. Unit Method

3. Factor
 4.4.1 Cost Indexes (or Ratio Technique)
 Definition: Cost Index is ratio of cost today to cost in the past
• Indicates change in cost over time; therefore, they account for the
impact of inflation
• Index is dimensionless
• CPI (Consumer Price Index) is a good example

Formula
Formula forcost
for total totalis
cost is
Example: Cost Index Method
Problem: Estimate the total cost of labor today in US dollars for a
maritime construction project using data from a similar project in
Europe completed in 1998.
Labor index, 1998: 789.6 Cost in 1998: €3.9 million
Labor index, current: 1165.8 Currently, 1 € = 1.5 US$

Solution: Let t = today and 0 = 1998 base

Ct = 3.9 million × (1165.8/789.6) = €5.76 million

= €5.76 × 1.5 = $8.64 million
 4.4.2 Unit Method
 Commonly used technique for preliminary design stage estimates
 Total cost estimate CT is per unit cost (u) times number of units (N)
CT = u × N
 Example uses:
 Cost to operate a car at 60¢/mile for 500 miles: CT = 0.60 × 500 = $300
 Cost to build a 250 m2 house at $2250/m2: CT = 2250 × 250 = $562,500

 Cost factors must be updated periodically to remain timely

When several components are involved, estimate cost of each component and
add to determine total cost estimate CT
 4.4.3 Factor Technique

The factor technique is an extension of the unit method in which we

sum the product of several quantities or components and add these to
any components estimated directly.
Problem 1 (Answer: Total cost = $1,227,250)
(3.15) In a building construction project, 7,500 feet of insulated
ductwork is required. The ductwork is made from 14-gauge steel
costing $8.50 per pound. The 24-inch-diameter duct weighs 15
pounds per foot. Insulation for the ductwork costs $10 per foot.
Engineering design will cost $16,000, and labor to install the
ductwork will amount to $180,000.

What is the total cost of the installed ductwork for this project?
Problem 2 (Answer: Estimated cost = $1,274,515.)
(3.16) A biotech firm is considering abandoning its old plant, built
23 years ago, and constructing a new facility that has 50% more
square footage. The original cost of the old facility was $300,000,
and its capacity in terms of standardized production units is
250,000 units per year.

The capacity of the new laboratory is to be 400,000 units per year.

During the past 23 years, costs of laboratory construction have
risen by an average of 5% per year. If the cost-capacity factor,
based on square footage, is 0.80,what is the estimated cost of the
new laboratory?
Problem 3 (Total cost with options = $354,879 )
(3.11) The purchase price of a natural gas-fired commercial boiler
(capacity X) was $181,000 eight years ago. Another boiler of the
same basic design, except with capacity 1.42X, is currently being
considered for purchase. If it is purchased, some optional features
presently costing $28,000 would be added for your application.

If the cost index was 162 for this type of equipment when the
capacity X boiler was purchased and is 221 now, and the
applicable cost capacity factor is 0.8, what is your estimate of the
purchase price for the new boiler?
Problem 4 (Answer = 4,497 units)
(3.35) Given the following information, how many units must be
sold to achieve a profit of $25,000? [Note that the units sold must
account for total production costs (direct and overhead) plus
desired profit.]
Direct labor hours: 0.2 hour/unit
Direct labor costs: $21.00/hour
Direct materials cost: $4.00/unit
Overhead costs: 120% of direct labor
Packaging and shipping: $1.20/unit
Selling price: $20.00/unit