ENGINEERING ECONOMICS (BPK 30902)

Chapter 2

FUNDAMENTAL COST CONCEPTS

ZUIKARNAIN DAUD

Contents
1. 2. 3. 4. 5. 6. 7. 8. 9. Introduction Cost Terminology Fixed Cost, Variable Costs and Total Costs Recurring and Non-recurring Cost Direct, Indirect and Standard Costs Cash Cost versus Book Cost Sunk Cost Opportunity Cost Life-Cycle Cost

Introduction
Cost terminology and concepts (the meaning and use of various cost terms and concepts) are important in engineering economy (EE) to be understood in order to commutate effectively with order engineering and management personnel The use of present economy studies in engineering decision making can provide satisfactory results and save considerable analysis effort by considering the various monetary consequences that occur in short time period

Cost Terminology
A variety of costs that to be considered in EE analysis Costs differ in frequency of accurrence, relative magnitude and degree of impact by defining a number of cost categories and illustrate how they should be treated

Fixed Cost, Variable Costs & Total Costs

Fixed Cost Unaffected by changes in activity level feasible range in operation E.g. Insurance, general management & admintrative salaries etc

Fixed Cost, Variable Costs & Total Costs

Variable Cost
Those associated with operation taht vary in total with quantityof output or other measure of activity level E.g. Cost s of material & labor used in a product or service

Fixed Cost, Variable Costs & Total Costs

Total Costs
Sum of fixed costs & variable cost

Fixed Cost, Variable Costs & Total Costs

Exercise A group of EE study team is making analysis in a decision to produce a new product in two alternative site. Details are as follows:
Site A Variable Cost (RM per unit) Fixed Cost (RM per month) Production Capacity (unit per month) 1.20 5,000 10,000 Site B 0.90 7,500 15,000

Fixed Cost, Variable Costs & Total Costs

Solution: The most economic total cost is RM1.40 per unit for site B due to the higher capacity of production of 15,000 unit per month. If the production is limited to 10,000 units per month, the total cost for Site B per unit is still lower at RM1.65 only compare to site A. However total cost needed for site B is RM21,000 per month compare to site A of RM17,000 per month only.
Site A Variable Cost ( RM per month Fixed Cost (RM per month) Total Costs (RM per month) Total Cost (per unit) Total Costs at 10,000 unit output 12,000 5,000 17,000 1.70 17,000 Site B 13,500 7,500 21,000 1.40 16,500

Recurring and Nonrecurring Cost

Recurring Cost
Annual expenses items for direct & indirect cost associated with five primary resouces E.g. people, machines, materials, energy & information - major part expenses

Non-recurring Cost
Expenses for shutting down operation & retirement & disposal of assests E.g. Personnal, materials, transportation etc

Direct, Indirect and Standard Costs

Direct costs
Costs that can be reasonably measured and allocated to a specific output or work activity E.g. Labour & material costs directly associated with product, service or construction activity

Direct, Indirect and Standard Costs

Indirect
Costs that are difficult to attribute or allocate to a specific output or work activity E.g. Overhead include electricity, general repairs, supervision etc

Direct, Indirect and Standard Costs

Standard costs
Planned costs per unit of output that are establised in advance of actual production or sevice delivery Developed from anticipated direct labour hours, materials & overhead categories (level of porduction)

Direct, Indirect and Standard Costs

Standard costs
Plays an important role & other management fuctions as
Estimating future manufacturing costs Measuring operating performace by comparing actualncost per unitwith standard unit cost Preparing bid on product or service requested by customers Establishing the value of work in process & finised inventories

Cash Cost versus Book Cost

Cash cost
A cost that involves payment of cash Estimated from the prespective establised for the analysis & are the future expenses inccured for the alternatives be ing analyzed In EE analysis , only those costs thats are cash flows or potential cash flows to be considered

Cash Cost versus Book Cost

Book cost (noncash cost)
A cost that does not involves a cash transaction and its relected in the accounting system Represent the recovery of past expenditures over a fixed period of time E.g. Depreciation (not a cash flows) charged on assets such as machines & equipment

Sunk Cost
Occurred in the past & no relevance to estimate future costs & revenues related to an alternative course of action Common to all alternative, is not part of the future cash flows & disregarded in EE analysis Non-refundable cash outlays e.g earnest money on a house or money spent on a passport

Sunk Cost
Example The firm is considering to replace of equipment. Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of replacement sunk cost is RM50,000. However on view is RM20,000 less RM5,000 is RM15,000. Neither RM50,000 or RM15,000 should be consider by EE analyze

Opportunity Cost
Incurred due to the use of limited resourses for monetary advantage in alternative use if fore gone Cost of best rejected opportunity & often hidden or implied

Opportunity Cost
Example The firm is considering to replace of equipment. Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of EE analysis, even to replace, by keeping the equipment, the new opportunity value of RM5,000 obtain from its disposal

Life-Cycle Cost
Refers to a summation of all the costs related to a product, structure, system, or service during its life spin Begins with identification of the economic need/want & ends with retirement & disposal activities It is airtime horrizon that must be defined in the context of the specific situation e.g. Highway, engine, aircraft, manufacturing etc Divided two general time periods; acquisition phase & operation phase

Phase Of The Life-Cycle & Relative Cost

High Potential for life-cycle cost saving

Cumulative life-cycle cost

Cost (RM)

Cumulative commited life-cycle cost Time Needs assessment: defination of requirement Conceptual (preliminary) design: advanced development prototype testing Details design production or construction planning: facility & resources accquisition Production or construction

Operation or customer use: maintenance & support

Retirement & disposal

Acquisition Phase

Operation Phase

Life-Cycle Cost - Acquisition phase

Needs assessment: definition of requirement
Analysis of the economic need/want Make explicit the requirement for the product, structure, system or service

Conceptual (preliminary) design: advanced development prototype testing

Proceed in a logical sequence Defined technical & operational requirement into proffered preliminary design

Life-Cycle Cost - Acquisition phase

Details design production or contruction planning: facility & resource accquisition
Details design & planning for production or construction Followed by activities necessary to prepare ,acquire & make ready for operation the facilities & other resources needed

EE studies are an essential part of design process to analyze & compare alternatives & to assist in determing the final details design

Life-Cycle Cost - Operation phase

Production or construction Operation or customer use: maintenance & support Retirement & disposal
EE studies priorities 1. Achieving efficient & effective support tooperation 2. Determining replacement of assets should b occur 3. Projecting the timing of retirement & disposal activities

Life-Cycle Cost - Categories

1. Investment cost
Capital required for most activities in the acquisition phase E.g. Single expenditure & series of expenditure

2. Working capital cost

Funds required for the start-up & support of operational activities E.g. Material for product/ spare part for maintenance/ cash for salaries etc

Life-Cycle Cost - Categories

3. Operation & maintenance cost

Includes many of the recurring annual expenses items associated with operation phase of LC Direct & indirect cost of operation associated with 5 primary resources (people/machines, materials/ energy/ information
Includes those non-recurring costs of shutting down the operation & the retirement & disposal of assets at of LC

4. Disposal cost

Quick Revision
Classify each of the following cost items as mostly fixed or variable
Raw Materials Direct Labour Depreciation Supplies Utilities Property taxes Interest on borrowing money Admin salaries Payroll taxes Insurance (building &equipment) Clerical salaries Sales Commissions Rent

Quiz 1
A group of EE team is making analysis in a decision to produce a new product in two alternative site. Details are as follows:
Site A Variable Cost (RM per unit) Fixed Cost (RM per month) Production Capacity (unit per month at single shift ) 1.40 6,500 10,000 Site B 1.00 9,000 20,000

Calculate:1. Total Variable Cost (TVC) 2. Total Production Cost (TPC) 3. Total Cost (TC) 4. Suggest the most economic site for production if the consumer demand is 20, 000 units per month, explain why?

Answer QUIZ 1
Q 1 Total Variable Cost (per shift) Total Production Cost (per month) Total Cost (per month) 3 Site A VC x TP RM1.40 x 10,000 = RM14,000 TVC x TPn RM14,000 x 2 = RM28,000 TPC + FC RM28,000 + RM6,500 = RM34,500 Site B VC x TP RM1.00 x 20,000 =RM20,000 TVC x TPn RM20,000 x 1 = RM20,000 TPC + FC RM20,000 + RM9,000 = RM29,000

Recommendation by EE team: Site B is the most economic site because of lower cost of RM5,500 then Site A and able to fulfill the consumer demand

Thank You