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CHAPTER 2

COST CONCEPTS AND DESIGN

ECONOMICS Part 3

CIVL5204/SP17 Engineering Economics 1

 2.2.6 Cost, Volume, and Breakeven
Point Relationships
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You paid 5,000 R.O for a car, drove it for 6 months

and sold it to a friend for 5,000 R.O.
How did you do? Gained or lost?

Breakeven Point is the point at which sales of products or

services make no profit. It just covers the costs.
Its not always possible to maximize profit by maximizing
revenue because of the cost-volume relationship
Cost-volume relationship must be considered and related to
revenue
Cost reduction gives a key motivation for many engineering
process improvement
 At any time, the total cost is
Total Cost = Fixed cost + Variable cost
(CT = CF + CV)
For linear relationship assumed
here, CV = cv.D,
where cv is the variable cost per unit.

There are two scenarios for

finding breakeven point
(revenue = total cost):
1- Demand is a function of price.
2- Price and Demand are
independent on each other.
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 Combined Cost and Revenue Functions and Breakeven Points

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 Profit is maximum where
Total Revenue exceeds
Total Cost by greatest amount Profit = TR - Ct d (TR ) dC
Max. Profit at t

Maximum
dD dD
Profit
Ct = Cf + cv D
Cost / Revenue

Profit
Total Revenue

Cf

Quantity ( Output )
D1 D* D2 Demand
D1 and D2 are breakeven points

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 PROFIT MAXIMIZATION D*
Occurs where total revenue exceeds total cost by
the greatest amount;
Occurs where dTR/dD = d Ct /dD;
Profit = (a D b D2) (Cf + cv D), or
Profit = - b D2 + (a cv) D Cf, then at
Positive and large (a cv) D produce positive profit
and avoid negative demand.
Max. Profit , D* = [ a - cv] / 2 b, then check
d2(profit)/dD2 < zero = -2 b, to be sure that you
6 dont have an inflection point.
 BREAKEVEN POINTS D1 and D2

Occurs where TR = Ct
( aD b D2 ) = Cf + cv D
- b D2 + [ a - cv ] D - Cf = 0, Solve for Breakeven
Points to get D1 and D2 [To have at least one
breakeven point (a - cv) > 0, to have zero for the Left
Side of the equation]
Using the quadratic formula:

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(a cv ) (a cv ) 4(b)(C F )
2 2
D
'

2b

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 2.3 Cost driven design optimization
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Engineers must maintain a life-cycle viewpoint as they

design products, processes and services. (cradle to
grave).
A movement called Design for the environment (DFE)
or green engineering has resources among its goals.
Example: designing for energy conservation, the
design of an automobile bumper that can easily
recycled.
Engineering is an economically driven art
 Engineers should consider:
Initial investment costs
Operation and maintenance expenses
Other annual expenses in later years
Environmental and social consequences over design life.

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Cost driven design optimization are simple

design
models intended to illustrate the importance of
cost in the design process
These problems show the procedure for
determining an optimal design, using cost
concepts.
We will consider a single design variable X also
called primary cost driven
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COST-DRIVEN DESIGN OPTIMIZATION PROBLEM TASKS

1. Determine optimal value for certain alternatives

design variable.

2. Select the best alternative, each with its own

unique value for the design variable.

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 COST-DRIVEN DESIGN OPTIMIZATION PROBLEM COST TYPES

1. Fixed cost(s)
2. Cost(s) that vary directly with the design variable
3. Cost(s) that vary indirectly with the design variable
Simplified Format of Cost Model With One Design Variable

Cost = aX + (b / X) + k
a is a parameter that represents directly varying cost(s)
b is a parameter that represents indirectly varying cost(s)
k is a parameter that represents the faced cost(s)
X represents the design variable in question
(In a particular problem, the parameters a,b and k may actually
represent the sum of a group of costs in that category, and the design
variable may be raised to some power for either directly or indirectly
varying costs.)
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 GENERAL APPROACH FOR OPTIMIZING A DESIGN
WITH RESPECT TO COST

1. Identify primary cost-driving design variable

2. Write an expression for the cost model in terms of the
design variable
3. Set first derivative of cost model with respect to
continuous design variable equal to 0. (Solve equation
in step 3 for optimum value of continuous design
variables
4. For continuous design variables, use the second
derivative of the cost model with respect to the design
variable to determine whether optimum corresponds
to global maximum or minimum.

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 Practice Exercise
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 Total annual cost (TAC) = Fixed Cost + Cost of Heat
Loss
TAC = 450X + 50 + 4,8/X1/2.
D(TAC)/dx = 0 = 450 2.40/X3/2
X3/2 = 2.40/450 = 0.00533
X* = 0.0305 meters
d2 (TAC)/dX2 = 3.6/X5/2 > 0 For X >0
Since the second derivative is positive, X* = 0.0305
meters is a minimum cost thickness.
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 2.4 PRESENT ECONOMY STUDIES
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When alternatives for accomplishing a task are

compared for one year or less (i.e., influence of time
on money is irrelevant).

The relationship between interest and time leads to

the concept of the time value of money.

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Rules for Selecting Preferred Alternative

Rule 1: When revenues and other economic benefits

are present and vary among alternatives, choose
alternative that maximizes overall profitability based
on the number of defect-free units of output.

Rule 2: When revenues and economic benefits are not

present or are constant among alternatives, consider
only costs and select alternative that minimizes total
cost per defect-free output.
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Total Cost in Material Selection (Example 2-8)

In many cases, selection of among materials cannot be based
solely on costs of materials. Frequently, change in materials
affect design, processing, and shipping costs.

Alternative Machine Speeds (Example 2-9)

Machines can frequently be operated at different speeds,
resulting in different rates of product output. However, this
usually results in different frequencies of machine downtime.
Such situations lead to present economy studies to
determine preferred operating speed.
 Make Versus Purchase (Outsourcing) Studies (Example: 2-10)

A company may choose to produce an item in house,

rather than purchase from a supplier at a price lower
than standard production costs if:
1. direct, indirect or overhead costs are incurred regardless
of whether the item is purchased from an outside
supplier, and
2. The incremental cost of producing the item in the short
run is less than the suppliers price
The relevant short-run costs of the make versus
purchase decisions are the incremental costs incurred
and the opportunity costs of resources
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 Opportunity cost is the best alternative forgone when
we make a choice

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 The Production Possibilities Curve
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 Economic Growth
If an economy is operating at a point on the production
possibilities curve, all resources are used, and they are
used as efficiently as possible.

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 Example - Make versus Purchase Studies

Given:
The company is currently purchasing a part and is
considering manufacturing the part in-house. This
company is not operating at full capacity, and no other use
for the excess capacity is contemplated. Unit costs are
given below.

Find:
Should the part be made in-house or purchased?
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 Solution - Make versus Purchase Studies

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 Summery
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Cost, Volume, and Breakeven Point Relationships

Profit maximization
Cost driven design optimization
Time value of money
Make vs. purchase study
 Self-Assignment
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Read pages 52-73 of:

Sullivan W.G., Wicks, E. M., and Koelling, C.P. (2012).
Engineering Economy - 15th edition, Harlow(Essex):
Pearson Education Ltd.
Practice:
example 2-5 (page 59-60) and example 2-9 (page 67-68)
Answer these Questions:
2-2. Classifying cost items
2-10. Life-cycle cost concept