Engineering Economics &

Optimization
Lecture#2
Cost of a Product
 Elements of Costs
COST

Variable Overhead
Cost Cost

Direct Direct
Direct Factory Administr
Material Labor Selling Distribution
Expense Overhead ative
Cost Cost
Variable Cost
Cost that varies with the production volume.

Example#1
1 shirt 2 shirts 3 shirts
Cloth (Direct
6m 12m 18m
Materials)
Labor
(Direct 8hrs 16hrs 24hrs
Labor)
Variable Cost
Direct Material Cost: Cost of material that are used to produce the product.
Examples:
• Timber in furniture making.
• Cloth in dress making.
• Bricks in Construction
Direct Labor Cost: Amount of Wages paid to direct labor involved in
production activities.
Examples:
• Carpenters and helping staff
• Tailor Master
• Masons,contractors,welders etc.
Variable Cost
Direct Expense Cost: Those expenses that vary in relation to the
production volume other than direct labor cost and direct material
cost.
Examples:
Labor and payroll taxes paid based on the number of units
produced
The commission and payroll taxes related to the sale of goods or
services
The cost of the freight needed to transport goods to and from a
manufacturing facility
Overhead Cost
Overhead cost is fixed irrespective of production volume.

Example
Rent, Gas, Electricity
Overhead expenses include accounting fees, advertising,
insurance, interest, legal fees, labor burden, rent, repairs,
supplies, taxes, telephone bills, travel expenditure.
Overhead Cost
Factory Overhead Cost: It is the aggregate of indirect material cost,
indirect labor and indirect expenses.
Examples:
• Electricity to operate the factory equipment,
• Depreciation on the factory equipment and building.
• Factory Supplies.
Administration Overhead Cost: Costs that are incurred in
administering the business
Examples:
• Front office and sales salaries, wages, and commissions
• Administration of sales office .
 Overhead Cost
Selling Overhead Cost: Total expense incurred in administering
the promotional activities and expenses related to sales force.
Examples:
• Warehouse rent and expenses.
• Depreciation of delivery vans.
Distribution Overhead Cost: Total cost of shipping the item
from factory site to customer site.
Examples:
Freight and Carriage
Sales Representatives
BREAK-EVEN ANALYSIS
Break-even analysis is a technique based on categorizing production costs
between those which are "variable" (costs that change when the production
output changes) and those that are "fixed" (costs not directly related to the
volume of production).

Total variable and fixed costs are compared with sales revenue in order to
determine the level of sales volume, sales value or production at which the
business makes neither a profit nor a loss (the "break-even point").

The main objective of break-even analysis is to find the cut-off production

volume from where a firm will make profit.
BREAK-EVEN ANALYSIS
The total sales revenue (S) of the firm is given by the following formula:
S=sxQ
The total cost of the firm for a given production volume is given as
TC = Total variable cost + Fixed cost
= v x Q + FC
s = selling price per unit
v = variable cost per unit
FC = fixed cost per period
Q = volume of production
Profit = Sales – (Fixed cost + Variable costs)
= s x Q – (FC + v x Q)
Break Even Analysis
Break Even Analysis
 Break Even Analysis

Example#1
Example#2

Fixed factory overhead Cost=Rs. 60000

Fixed selling overhead cost=Rs. 12000
variable manufacturing cost per unit= Rs.12
variable selling cost per unit=Rs. 3
Selling price per unit= Rs. 24
Example#3

Gandhara Industries is a major producer of diverter dampers used in the gas

turbine power industry to divert gas exhausts from the turbine to a side
stack, thus reducing the noise to acceptable levels for human environments.
Normal production level is 60 diverter systems per month, but due to
significantly improved economic conditions in Asia, production is at 72 per
month. The following information is available
Fixed costs = Rs. 2.4 million per month
Variable cost per unit = Rs. 35,000
Revenue per unit = Rs. 75,000
a). How does the increased production level of 72 units per month
compare with the current breakeven point?
(b) What is the current profit level per month for the facility?
(c) What is the difference between the revenue and variable cost per
damper that is necessary to break even at a significantly reduced
monthly production level of 45 units, if fixed costs remain constant?
Exapmle#4

PNG electric company manufactures a number of electric products. Rechargeable

light is one of the PNG’s products that sells for Rs.180/unit. Total fixed expenses
related to rechargeable electric light are Rs.270,000 per month and variable
expenses involved in manufacturing this product are Rs.126 per unit. Monthly sales
are 8,000 rechargeable lights

Compute break-even point of the company in (Quantity)

Sol 2
Sol 3
Sol 4
• Sales = Variable expenses + Fixed expenses
• $180Q = $126Q + 270,000
• $180Q – $126Q = $270,000
• $54Q = $270,000
• Q = $270,000/$54
• Q = 5,000 Units
Contribution

The contribution margin is calculated by subtracting an item’s variable

costs from the selling price. So if you’re selling a product for $100 and
the cost of materials and labor is $40, then the contribution margin is
$60. This $60 is then used to cover the fixed costs, and if there is any
money left after that, it’s your net profit.
Margin of safety
Margin of safety indicates the amount of sales that are above the
break-even point.
Let's assume that a company currently sells 3,000 units of its only
product. The company has estimated that its break-even point is 2,800
units. Therefore, the company's margin of safety is 200 units.
The Profit Volume (P/V) Ratio is the measurement of the rate of change
of profit due to change in volume of sales. It is one of the important
ratios for computing profitability as it indicates contribution earned
with respect of sales.