ENG 3000 Summer 2018

Module 2: Engineering Costs

Reference:
Newnan, D., Jones, J., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Can. ed.). Oxford University Press.

Learning Objectives
• Define various cost concepts
• Understand importance of engineering cost concepts
• Draw Cash Flow Diagrams to show project costs and benefits

Engineering Costs
• Costs analyzed to evaluate alternatives

• Fixed cost:
– Constant, unchanging cost regardless of output or activity level
• Variable cost:
– Changes depending on output or activity level
• Marginal cost:
– Variable cost for one more unit
• Average cost:
– Total cost divided by number of units

• Total Cost = total fixed cost + total variable cost

Figure 1: Fixed, Variable and Total Costs: Example (Newnan et al. 2011)

• Break-even point can be used to create profit-loss break-even chart

• Breakeven point: total costs = total revenue
• Profit region: total revenue > total costs
• Loss region: total costs > total revenue

Page 1 of 8
ENG 3000 Summer 2018

Figure 2: Profit-Loss Break-Even Chart: Example (Newnan et al. 2011)

Other Types of Costs

• Sunk costs
– Money already spent as result of past decisions
– Disregarded in engineering economic analysis
• Nothing can be done now to change past cost
– Engineering economists deal with present and future opportunities only

• Opportunity costs
– Costs associated with using resource for alternate task
– “Benefit that is forgone by engaging a business resource in a chosen activity instead of
engaging that same resource in a forgone activity”

• Recurring costs
– Cost occurring at regular intervals
– Can be estimated and thus included in overall cash flow analysis

• Non-Recurring costs
– One-of-a-kind costs recurring at irregular intervals
– Difficult to plan for or anticipate from budgeting perspective

• Incremental Costs
– Cost differences between alternatives

• Cash Costs versus Book Costs

– Cash costs
• Cash transactions or cash flows
• e.g. If company purchases asset, it realizes cash cost
– Book costs
• Not cash transactions or cash flows
• Accounting entry representing some change in value
• Recorded in company’s accounting books
• e.g. Asset depreciation

Life Cycle Costs

• Goods and services progress through life cycle
– Duration of different phases changes depending on good and service

Page 2 of 8
ENG 3000 Summer 2018

• Life-cycle costing
– Concept of designing products, goods and services with recognition of associated costs
over various phases of their life cycles
– The later the design change made, the higher the cost
– Decisions made early in life cycle “lock in” costs incurred later

Figure 3: Typical Life Cycle for Products, Goods and Services (Newnan et al. 2011)

Figure 4: Cumulative Life Cycle Costs Committed and Dollars Spent

Page 3 of 8
ENG 3000 Summer 2018

Figure 5: Life Cycle Design Change Cost and Ease of Change

Cash Flow Diagrams

• Costs and benefits over time can be represented by cash flow diagram
• Cash flows assumed to occur at time 0 or at end of each period

Table 1: Cash Flow Diagram: Example

Figure 6: Cash Flow Diagram: Example

• Categories of cash flows

– First cost

Page 4 of 8
ENG 3000 Summer 2018

• Expense to build or buy and install

– Operations and maintenance
• Annual expense, e.g. electricity, labour and minor repairs
– Salvage value
• Receipt at project termination for sale or transfer of equipment
– Revenues
• Annual receipts due to sale of products or services
– Overhaul
• Major capital expenditure during life of asset

Example 1
Problem
An entrepreneur named DK is considering chartering a bus to take a group of people to an event in a
larger city. DK plans to provide transportation, tickets to the event, and refreshments on the bus. He
gathered and categorized the predicted expenses as follows:

Assume DK charges $35 per person, determine DK’s total profit if 30 people take the bus to go to the
event.

Solution
DK’s fixed costs will be incurred regardless of how many people sign up for the trip.

DK’s variable costs depend on how many people sign up for the charter:

DK’s total cost:

DK’s total revenue:

DK’s total profit:

Page 5 of 8
ENG 3000 Summer 2018

Example 2
Problem
A distributor of electric pumps must decide what to do with a lot of old electric pumps purchased three
years ago. Soon after the distributor purchased the lot, technology advances made the old pumps
obsolete. The pricing manager has the following information:

Distributor’s purchase price three years ago $7,000

Distributor’s storage costs to date 1,000
Distributor’s list price three years ago 9,500
Current list price of the same number of new pumps 12,000
Amount offered for the old pumps from a buyer two years ago 5,000
Current price the lot of old pumps would bring 3,000

Looking at the data, the pricing manager concludes that the price should be set at $8,000. This is the
money the firm has spent on the lot ($7,000 purchase and $1,000 storage), so the company should
recover this cost at least. It would also be $1,500 less than the list price from three years ago, and it
would be $4,000 less what a lot of new pumps would cost. What would be your advice on price?

Solution
Data Items Analysis:
- Distributor’s purchase price three years ago: sunk cost that should not be considered in setting
price today
- Distributor’s storage costs to date: storage costs for keeping pumps in inventory, also sunk costs,
should not influence pricing decision
- Distributor’s list price three years ago: If there was no willing buyers in past three years at this
price, it’s unlikely buyer will emerge in future. Should have no influence on current pricing
decision
- Current list price of newer pumps: newer pumps now include technology and features that have
made old pumps less valuable. Comparing old to new pumps is misleading. However, price of
new pumps helps determine market value of old ones
- Amount offered by a buyer two years ago: foregone opportunity. At the time, the company chose
to keep lot, and thus the $5,000 became an opportunity cost to keep pumps. Should not influence
current pricing decision.
- Current price the lot could bring: price willing buyer offers is called asset’s market value. Lot of old
pumps believed to have current market value of $3,000.

In an engineering economic analysis, we deal only with today’s and prospective future opportunities. It is
impossible to go back in time and change decisions that have been made. Thus the pricing manager
should recommend to the distributor that the price be set at the current value that a buyer assigns to the
item: $3,000.

Example 3
Problem

Page 6 of 8
ENG 3000 Summer 2018

Philip is choosing between model A and model B (with more features and a higher purchase price). What
incremental costs would Philip incur if he chose model B instead of the less expensive model A?

Solution
Incremental costs would be as follows:

Positive incremental costs mean that model B costs more than model A. Negative incremental costs
mean that there would be savings if model B were chosen instead.

Example 4
Problem
A manager has decided to purchase a new $30,000 mixing machine. The machine may be paid for in one
of two ways:
1. Pay the full price now minus a 3% discount.
2. Pay $5,000 now; at the end of one year, pay $8,000; at the end of each of the next four years,
pay $6,000.
List the alternatives in the form of a table and cash flows.

Solution

Page 7 of 8
ENG 3000 Summer 2018

Page 8 of 8