Sequence 6 _ Some Theoretical

Concepts_ Engineering Economics

Dr. Muhammad Israr

Mechanical Engineering Technology
Fixed, Variable, Marginal and Average Costs
Fixed, Variable, Marginal and Average Costs

Fixed Costs are constant or unchanging regardless of the level of

output or activity. In contrast, variable costs depend on the level of
output activity. A marginal cost is the variable cost for one more unit,
while the average cost is the total cost divided by the number of
units.

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 Difference b/w fixed and variable costs
In a production environment, for example fixed costs, such as those
for factory floor space and equipment, remain the same even though
production quantity, number of employees, and level of work-in-
process may vary. Labor costs are classified as a variable cost
because they depend on the number of employees and the number of
hours they work. Thus fixed costs are level or constant regardless of
output or activity, and variable costs are changing and related to the
level of output or activity.

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 Difference between Fixed and Variable Costs
As another example, many universities charge full-time students a
fixed cost for 12 to 18 hours and a cost per credit hour for each
credit hour over 18. Thus for full-time students who are taking an
overload (>18 hours), there is a variable cost that depends on the
level of activity, but for most full-time students tuition is a fixed
cost.

This example can also be used to distinguish between marginal and

average costs. A marginal cost is the cost of one more unit. This will
depend on how many credit hours the student is taking. If currently
enrolled for 12 to 17 hours, adding one more is free. The marginal
cost of an additional credit hour is $0. However, for a student taking
18 or more hours, the marginal cost equals the variable cost of one
more hour.

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 Illustration on calculating average cost
To illustrate average costs, the fixed and variable costs need to be
specified. Suppose the cost of 12 to 18 hours is $1800 per term and
overload credit hours are $120/hour. If a student take 12 hours, the
average cost is $1800/12=$150 per credit hour. If the student were to
take 18 hours, the average cost would decrease to $1800/18=$100
per credit hour. If the student takes 21 hours, the average cost is
$102.86 per credit hour [ $1800 + (3x$120)]/21. Average cost is this
calculated by dividing the total cost for all units by the total number
of units. Decision makers use average cost to attain an overall
cost picture of the investment on a per unit basis.

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 The Use of Marginal Cost
Marginal cost is used to decide whether an additional unit should be
made, purchased, or enrolled in. For our example, full-time student,
the marginal cost of another credit is $0 or $120 depending on how
many credits the student has already signed up for.

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 Sunk Cost
Money already spent and permanently lost. Sunk costs are past
opportunity costs that are partially (as salvage, if any) or totally
irretrievable and, therefore, should be considered irrelevant to future
decision making. This term is from the oil industry where the
decision to abandon or operate an oil well is made on the basis of its
expected cash flows and not on how much money was spent in
drilling it. Also called embedded cost, prior year cost, stranded cost,
or sunk capital.

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 Opportunity Cost
If the investor is going to use cash that is available, they should
determine what rates of return can currently be obtained from
alternative investments of a similar risk. If you decide to invest your
cash in a construction project, you will be forgoing the returns from
an alternative project. This is known as the “ opportunity cost” of the
funds; so, for the construction investment to be justified, it has to be
equal to or greater than the alternative investments.

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Thank You