Section1 Cost

COST
Chapter 1
Cost Element
What is COST?
Creating Cost
Analysis Understanding Remembering Evaluating price paidApplying acquire, produce, The to accomplish, or maintain anything. Cost The total spent for goods or services including money, time and labor. Cost is the value of money that has been used up to produce something, and hence is not available for use anymore. Cost is the key element of triple constraint (Time, Cost, & Scope) by which project performance will be assessed.
Learning Objectives
Creating Evaluating Analysis Applying Understanding Remembering
At the end of this session, you should able to: Understand what cost constitutes; Understand Direct Cost, Indirect Cost, Fixed Cost & Variable Cost Understand the application of life cycle costing Use the cost element to measure, apply, and record to generate total activity and/or asset cost
Concepts
Cost is the total value of an assets or activity. To arrive to this value, the cost of the resources
utilized to perform activity or to create assets is calculated. Resources are categorized in to:
Material Labor Other
Cost Categories
Material
Material are not only the physical part of an asset, but also includes failure cost like scraps, construction form works, safety items, and logistics cost to transport the material to the work place.
Labor
The cost incurred for the entire project team from laborer to foreman to project engineer to project manager.
These cost categories are required to support the work. Cost expended for Equipments, Water, Electricity, Maintenance etc.,
Other
Cost Structuring
Cost structuring will help to get clear picture of
how the cost is expended on the project like whether it is a direct cost or indirect cost. If it is direct or indirect cost, is it fixed or variable cost ? By classifying the cost in to direct, indirect, fixed, & variable, the management can understand the cost expended for your project precisely which helps to do effective Estimating, Budgeting & Cost Control.
Cost Structuring: Direct Costs

The cost which is expended solely for the purpose
completing activities or assets for any given project. These costs cannot be shared among other projects. Direct cost are costs that can be associated with a particular cost object.
Cost Structuring: Indirect Costs

Indirect costs are costs that are not directly
accountable to a particular activity or asset. Indirect costs include taxes, administration, personnel and security costs. Indirect Costs are also known as Overhead Costs or Burden Costs.
Direct Cost + Overhead Cost = Total Object Cost
Cost Structuring: Fixed Costs

Fixed costs are expenses whose total does not
change in proportion to the activity of a business / project, within the relevant time period or scale of production. Fixed salary, Office Rent, Rented Crane for a fixed period of time, etc., are all examples of fixed cost. Fixed cost can be direct cost or indirect cost.
Cost Structuring: Variable Costs

Variable
costs are expenses that change in proportion to the activity of a business / project. Variable Costs can be direct cost or indirect cost.
Cost Accounting
Cost
accounting is the process of tracking, recording and analyzing costs associated with the products or activities of an organization.
Code of Accounts / Chart of Accounts

Based on the business practices, organization uses
Code of Accounts / Chart of Accounts to categories cost into groups to enter in to company accounts ledger. Code of Accounts will be presented in numeric codes.
For Example
2200 Accounts Receivable 2400 Inventory Materials and Supplies 7100 Site Preparation 7700 Electrical Systems
Code of Accounts / WBS

Code of Accounts for projects will be generally
based on Work Breakdown Structure numbering system.
Cost Management
Cost element and Cost structuring will be useful for
Cost Management. The information gathering by Cost Element and Cost Structuring will be useful for:

Cost Estimating Cost Trending Cost Forecasting Life-Cycle Costing
Discussed in detail in later sessions
Cost Estimating
Cost Estimating predicts the resource requirement
for an activity or to create an asset and the cost associate with it. For an accurate cost estimating, it is important to have:

A clear scope Cost element structure Historical information / Expert judgment
Cost Trending
Cost trending uses historical information as a basis
to estimate resource cost to complete an activity or an asset. It refers to historical information to find information's like:
How much did we spend for fixing tiles for the past 6 month and how much square meter tiles has been fixed? What is our monthly cost for electricity usage for the past one year?
Cost Forecasting
Estimating focuses on estimating future activities
and assets but in forecasting, the future cost expenditure will be predicted based on the past cost performance. Estimate to Complete, Estimate at Completion, Variance at Completion are all examples of Cost Forecasting.
Life-Cycle Costing
Life-Cycle
costing concerns with the cost associated in completing an activity or an assets and more importantly the cost of maintaining the assets through-out its life time. It includes service cost, maintenance cost, breakdown cost etc., It calculates the cost associated with an asset from its creation to disposal. Its an analysis of cost associated with product life cycle rather than focusing on project life cycle.
Chapter 2
Pricing
Cost vs. Pricing

Pricing is a cost we fix to buy or sell something. Pricing uses a set of tools and techniques to fix a
price for project/business. To fix a price for a product, services, or anything, we need key inputs like historical information, competitors information, WBS, Cost Estimation etc.,
Tools & Techniques of Pricing

Pricing Strategies Sales and Revenues Business and Economic Ratios Return on Investment Return on Sales Break-even analysis
Pricing Strategies
Pricing strategies should be based on the given
situation. When one is bidding for a project, there can be two situations:

Type I Type II
Type I acquisition is to win the project and perform
it successfully and profitably. Type II acquisition aims to win the project to get a foot hold in the industry.
Return on Investment
Rate of Return (ROR) or Return on Investment
(ROI), is the ratio of money gained or lost on an investment relative to the amount of money invested. ROI is usually given as a percent rather than decimal value. SIMPLE ROI (Gains Investment Cost) / Investment Cost
Complex ROI
ROI, also called as DUPONT or Engineers method
in complex calculations. It is the percentage relationship of the average profit to the original investment.
ROI=(average yearly profit during earning life)/(original fixed investment + working capital)
Other ROI Metrics

Return on Sales Net Profit / Sales Return on Assets Earnings before interest and taxes (EBIT) / Net Operating Assets Gross Profit Margin Ratio Gross Profit / Total Sales
Break Even Analysis

The break even point for a product is the point
where total revenue received equals total costs associated with the sale of the product.
Terms in use:
Selling Price Each unit price which it is sold for
Variable Costs Varies in proportionate with volume

Contribution Margin Sales revenue Variable cost Fixed Costs Remains constant irrespective of Sales
Units The number of items sold or produced
Formula
Break Even Unit X = FC / (SP-VC) or X = FC / CM
Break Even Revenue Break-even revenue = Break-even units X SP

Desirable Profit X = (FC + DP)/ CM
Chapter 3
Materials
Introduction
Materials are key substances used as inputs for
projects and production or manufacturing. Materials must be procured in right quantity at right time, failure in doing so, results in cost increase. There are other reasons also to have good materials management system in place like:

For material traceability purpose For effective control of damages to the material To reduce warehouse cost by following JIT system
Learning Objectives
At the end of this session, you should able to: Identify type of project materials; Understand the issues involved in selecting and handling materials; Understand the principles of material purchasing and management, including maintaining proper amount of stock to save money and avoid waste and production delays; Understand possible safety hazards associated with materials and be aware of the regulations governing worker and material safety.
Materials Competition
Materials
to be used in the project or manufacturing / production often have alternatives or choices. Floor tiles is a good example. We can fix granite, marble, Mosaic, etc., for the same functional use. In the above case the materials compete with each other in cost, constructability, customer preference, maintenance, life time, quality, etc.,
Materials Handling
Materials Handling Equ
Materials Handling Principles

Unit load Space utilization Material traceability Mechanization Shortest distance material movement Maintenance of Materials Handling Equipments
Materials Handling Decision Factors

While we take decisions on materials handling,
the following are the four factors to be considered:

1.
2.
3. 4.
The type of materials to be handled Production flow type (job shop/batch process & Continuous flow) Type of facility Cost of Materials Handling System
Material Types
1. Raw Materials (minimum processing e.g..
Gravel for road) 2. Bulk Materials (readily available with minimum lead time) 3. Fabricated Materials (bulk materials transformed into custom-fit items piping system w/fittings) 4. Engineered/Designed Materials (substantial working required to reach the final form pumps, motors, chillers, etc.)
Raw Materials
It requires minimum amount of processing.
Bulk Materials
Bulk materials are ready available Bulk materials are transformed in to fabricated
material or Engineered/Designed Materials
Fabricated Materials
Evaluating Analysis Applying Understanding Creating Custom-fit item for project or production. Remembering
Engineering/Designed Materials
It requires substantial work in order to achieve its
final form.
Production materials purchase and management

To complete an activity or to build an asset, we
need resources. These resources include materials. Materials need to be procured for project or operation, which becomes an important business function. Effectively materials procurement and handling will results in selling the products at competitive price. The ideal materials quality, quantity, safety stock will leads to cost optimization.
Production materials purchase and management

Materials quality management is handled through
proper vendor surveillance and materials traceability. Quality control plays a vital role in materials purchase. Should avoid gold-platting while purchasing materials for the project/production.
Materials Quantity
It is very important to consider the various factors
like material cost, storage cost, demand, etc., while purchasing materials to make sure we dont over stock the materials and under stock the materials. Economic Order Quantity comes for rescue. It gives a precise amount of quantity to buy considering all the factors.
Economic Order Quantity - EOQ

EOQ Formula
EOQ = [ (2 x D x P) / S]

D = Annual Demand P = Purchase Order Cost S = Storage / Carrying Cost
Re-order Point
RP = (O x R) + I

RP = Re-order point O = Order Time R = Production Rate I = Minimum Inventory level or safety stock
EOQ - Example
A garden tractor manufacturer has a requirement for 15,000 engines
per year. The engines each cost $75. The order cost for a purchase order is $250. The storage Cost for the engines are $12 per year which includes space costs and financing costs.

EOQ = [ (2 x D x P) / S] D = 15000 P= 250 S = 12 EOQ = 790
Re-order Point
Assume that the production processes uses 60
engines per day for the 60 garden tractors produced per day. If the lead time for an order is 5 days, and the safety stock level is 180 engines, what is the reorder point?

RP = (O x R) + I O = Order time = 5 R = Production Rate = 60 units per day I = Minimum Inventory = 180 Engines
RP = (5 x 60) + 180 = 480 Units
Just-In-Time Inventory Technique

Also known as KANBAN or 0% inventory. JIT system follows the principles of 0% inventory,
it maintains its system in such a way that exact amount of required material will be delivered at the required time and hence no need for warehouse and safety stock. System should be maintained proactively and carefully as poor JIT system results in production stoppage and loss of business due to unavailability of materials when it is required.
Individual purchase orders and systems contract

Customized and costly materials purchase needs to go
through the organization procurement process of request seller response, rate the vendor, select the vendor etc., For standard and routine purchases, the company may receive bid from prospective vendor and signs contract with them to received require materials quantity at frequent interval and on demand with economical price adjustment. The merits of this system is reduced procurement cost and economies of scale
Expediting
The purpose of expediting is to ensure that the
materials are delivered on-time as promised. Expediting is a key aspects in Critical path network. All the activities in critical path should received its associated materials on time as planned to ensure successful project completion.
Plant Materials Management

There are not part of final product objective but
rather supporting material for machines and equipment which is a part of production operation. Examples are oils, solvents, grease, etc., Specialized Plant Materials
Production equipment replacement parts Unique machinery needs to purchase spare parts from OEM with might require lead time
Plant Materials Benchmarking

Plant materials usage and life cycle should be
analyzed through benchmarking. Benchmarking is a practice of identify the best organization and follow their practices. While selecting plant materials an organization can identify the best performing organization and follow their procedures and practices in plant materials procurement and maintenance.
Materials waste product and Hazard issues

Users of hazardous materials should abide by the governmental
regulations. These regulations will ensure that hazardous material information is communicated to the employers and employees by labeling in work place like warning signs, material safety data sheet etc., For e.g., OHSA requires material safety data sheets should be readily available for all how may in need for it. There are also local governmental rules on waste materials disposal and allocation of a particular area for waste material disposal and it might requires treatment of waste materials before disposal.
Chapter 4
Labor
Labor Classifications
Direct Labor Personnel assigned to the work activities, who directly produce the product. Indirect Labor Personnel assigned to tasks other than producing products but they are required to complete the project. Overhead Labor Personnel assigned to task, which cannot be identified with a part of the work. Its a business expense independent of the volume of work. ( Refer Chapter 4, Page 4.1, Table 4.1 for examples)
Developing Labor Rates

Base wages Fringe Benefits [Paid Time Off] Medical & Life Insurance benefits Government Mandated benefits Engineer/Contractor overhead and profit Fully-Loaded or Billing Rate Overtime wages
Weighted Average Rates / Crew Composition Rates

In a craft area, group of workers perform the task
with different background, expertise etc., and their salary ranges from low to high. Since we dont know who will be part of the team while estimation, we can make some assumption in order to develop a comparable base wage rate to use. Weighted Average Rates method will be highly useful in this scenario.
Weighted Average Example

No 2 1
Classification Laborers Foreman
Hourly Base Wage $ 14 $ 25
Extension $ 28 $ 25
Carpenters
$ 18
$ 72
Average cost for the group = $ 125/7 = $ 17.85/hour with benefit adder of 30% = $ 23.1 / hour
Indirect and Overhead Labor

Indirect and Overhead Labor were previously
discussed. The cost incurred for Indirect and Overhead Labor will be estimated by several methods. For e.g.,

Actual estimate of indirect and overhead labor A percentage of Direct Cost (as directed by historical information)
Estimating Work Hours

Work hours estimation can be done only when
Class 3 estimation detail are available. Class 3 estimate can be performed when the requirements of major equipments, layout drawings, rough quantity of materials, etc., are determined.
Work Sampling
Work sampling is a technique to determine the
production or unit rates for a specific activity. Organization will use work sampling to develop strong estimation database by recording the duration of the sample work.
Chapter 5
Engineering
Introduction
Engineering is the basic foundation where product
prevail. With the advent of CAD/CAM, engineering is being revolutionized. Development of project, product and process ranges from simple to very complex and dynamic. There were different development in engineering field to cater this need.
Pure and Applied Research

New product development is based on research.
There are broadly two categories:
Pure Research
This involves work without a product in mind. E.g., A Chemist researching how two chemical compounds if mixed reacts.
Applied Research
This involves developing usable products or add new features to existing products and it is typically carried out by organizations.
Product, project, and process life cycle

The life cycle of product as well as project will
influence design decision, including plant and equipment.
CAD / CAE / CAM

CAD / CAE software involves the utilization of
computerized work stations and software, including database and computer graphics, to quickly develop a product, project, or process design. CAM provides the counterpart advantage of CAD/CAE software to the factory floor.
Prototypes
Before large scale production it is wise to develop
prototypes to check the feasibility in terms of design, performance, customer satisfaction etc., Advanced software's are available to create simulations of actual physical products. Computer simulations and prototypes will consume time but it gives a guarantee of final product performance.
Patents and Trade Secrets

New product development and research are very
expensive and company who spend enough money on R&D should reap the benefits. Patents and Trade Secrets protect them from others copies their hard worked design secrets. In united states, a patents duration is 17 years. Until this competitors should be copy the original producer model otherwise they will face severe law suits.
Product Liability
Product liability is a mean where those who get
injured or got damaged by the product they purchased can get compensated. Gone those old saying Buyer Beware now its Seller Beware While engineering team designs a product this should be considered to avoid product recalls, warranty claims etc.,
Product, Project, and Process Design

Standardization Process Selection

Continuous production, and

Discrete production
Manufacturability Constructability
CII defined constructability as the optimum use of construction knowledge and experience in planning, design, procurement, and field operation to achieve overall project objectives.
Make or Buy Decisions
Engineering Production/Construction
Production Health and Safety Facility Layout Assembly and Flow Process Charts Quantitative Analysis in Facility Layout Reengineering
Chapter 6
Equipment, Parts, and Tools
Introduction
Managing Equipment, Parts, and Tools includes: Selecting Purchasing Tracking Storing Maintaining Selling Equipment
Equipment Valuation
Establishing an equipment valuation database is a
key factor in project.
It helps to base the estimate for new equipment requirement for the project It helps to calculate the residual value for make or buy decision It helps project team to decide on trade-offs between men vs. machine
As equipment valuation database helps in key
decisive factor, emphasis should be given on quality of trade data.
Equipment Value Categories

Equipment values are in two major categories: 1. Replacement Cost New (new equipment cost), and 2. Market Value (used equipment, secondary market value)
Replacement Cost New

Reproduction Cost
Cost of a new identical equipment Current cost of replacing a equipment with a new one of equal effectiveness. Furthermore, replacement cost analysis takes into consideration the transportation and installation costs required to facilitate normal operation. Unbiased estimate of potential price considering

Replacement Cost
Fair Value
relative scarcity perceived utility (economist's term for subjective value based on personal needs) potential risk/return characteristics (i.e., for a tradable asset) production/distribution costs, including a cost of capital
Market Value
Fair Market Value-in-Place
Market value in place is the price at which equipment would change hands between a willing and able buyer and seller, with neither under compulsion to buy or sell, with both having full knowledge of the relevant facts. Including delivery, installation and put in to operation. The fair market value is the price at which the equipment would change hands between a willing buyer and a willing seller through third party transaction, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.
Fair Market Value-in-Exchange or Retail Value
Market Value
Orderly Liquidation Value Orderly liquidation is the value realized when assets are sold piecemeal, through negotiation, over a predetermined period of time (often three to six months). Orderly liquidation value assumes that the buyer is responsible for all removal costs and is purchasing the assets "as is, where is'" with no warrantees or representations as to the condition of the assets being made by the seller.
Market Value
Forced Liquidation Value / Under the hammer /
Blow-out Value
Forced liquidation value is the value realized when assets are sold piecemeal, under duress at public auction. Forced liquidation value assumes that the buyer is responsible for all costs of removal and is purchasing the assets "as is, where is" with no warrantees or representations as to the condition of the assets being made by the seller. It is further assumed that the assets are properly advertised in a manner considered to be commercially reasonable.
Market Value
Salvage Value / Part-One Value The estimated value of an asset at the end of its useful life. Scrap Value Scrap value is the value of equipment relates to basic commodity value. (For example, Dollars per ton of steel)
Valuation Example/Sub-Categories of Value

Type of Value Fair Market Value-in-Place Fair Market Value-in-Exchange Orderly Liquidation Value Forced Liquidation Value Salvage/Part-One Value
Sales Price $300,000 $225,000 $195,000 $150,000 $24,000
% of Highest Price 100% 75% 65% 50% 8%
Scrap Value
$6,000
2%
Data Source for Replacement Cost New

Price list of manufacturers Information provided by Sales Representative Technical and trade journal publications Invoices, Purchase Orders from past purchases Quotation received from vendors
Data Source for Market Value

Advertisement for used equipments Retail price received from used equipment dealer Used Equipment price quotation received earlier Market Data Publication Auction Sales Catalogs available from auction
companies Past remarketing and sales return
Market Value Example / Generator

Creating
Event a. Purchase price as-is at auction b. Sales tax c. De-installation d. Cost of Money (estimated) time to sell 90 Days, 10% annual rate x 3 months x $7500 purchase and install e. Overhead (20% of purchase price, includes some preparation and advertisement) f. Profit (15%-20%: use 20% of purchase price plus de-installation)
Evaluating
Analysis
Applying
Understanding Remembering
Cost/Value $7,000 (Orderly Liquidation Sale) Exempt (Equipment Dealer) $ 500 $ 175
$ 1400 $ 1500
g. Sub total (a+c+d+e+f)

h. Ask (advertise for sale) i. Take (sale to end user) j. Buyer (end user) pays sales tax (6%) k. Delivery I. Installation and debugging Total installed cost to end user (i+j+k+l)
$ 10575 (min. desired selling price)

$ 13000 $ 10700 (fair market value-in-exchange) $ 642 $ 750 $ 2000 $ 14092 (fair market value in place)
General Example Summary

Type of Market Value Fair Market Value-in-Place ($ 14092) Fair Market Value-in-Exchange
% of Value 100%
76%
($ 10700)
Orderly Liquidated Value 50%
($ 7000)
Trade Data/Cost Adjustments

If similar equipments sales data are inconsistent, the
following adjustment should be considered before normalizing the data:

The newer equipment manufacturing date attracts more value Different ancillary will add more value Sales locale Utilization Condition of the equipment
Equipment Condition Terms and Definition

Very Good equipment in excellent appearance and
being used to its full design specification Good equipment that was modified or repaired and being used to its full or near full design specification Fair equipment used at some point below fully specified utilization Poor it requires extensive repair and replacement of parts Scrap no longer serviceable and cannot be utilized.
Data Filling Systems

Obtained data can be recorded on several ways: Standard Industrial Classifications - #33 Machine Tools, #44 Marine, etc Equipment Class and Type tools-lathes, aircraft-commuter, construction-crawler crane Industry Category Machine shop equipment, Construction, Mining, etc Equipment Manufacturer name Caterpillar, Dewalt, etc., Data Storage Collected information can be stored electronically or through manual filing system
Equipment Valuation
One of the most propelling question for estimators
and appraisers is What is the residual value for the equipment? There is no short cuts to arrive to an residual value to decide on leases or life cycle costing, it should be calculate based on hard work and years of experience. The estimator or appraiser should understand the equipment and industry in which it operates. He should have access to trade data even though it doesnt guarantee the correctness.
Residual Value Curves

Residual Value Curves Shapes

L Shaped Normal curve for long-lived equipments U Shaped for Disrupted market or equipment
shortage Regulatory change curve which shows sudden impact of the equipment Truncated shape for high obsolescence equipment New Tax Law or High Inflation shift in L Shape
Variables that affect residual value

Creating
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12.
Evaluating
Analysis
Applying
Initial cost Maintenance Use/Wear and tear Population Age Economy Changes in Technology Foreign Exchange Tax Laws Legislations/regulations Location of equipment Method of Sales
Calculating Residual Values

Calculating residual values considering all the factors
is very difficult. Estimator / Appraisal can use all the available data and predict residual value to its closest accuracy is possible. Calculating residual value for long term equipments are quite challenging.
Residual Value Formats

Creating

Evaluating
Analysis
Applying
Marketplace Manufacturer Model Run Installation Software Versatility Life Expectancy Residual Value Manufacturing Market Place Future Improvements Price Increases De-Installation Conclusion
Residual Curves
Methodology
1. 2. 3. 4. 5. 6.
7.
A Complete market analysis and technical review of the equipment. Current fair value after considering discounts and other general offers. With fair value and all other trade data, valuation history is completed After analyzing trade data, an average is determined and entered onto the residual analysis line. The residual value in percentage is calculated based on the given data. It has to be streamlined with other adjustment factors (Tax, Regulation) Final Review and cross-checked with other curves.
Inflation Factors
Residual value analysis does not consider inflation
factors. However, if one likes, he can apply inflation factor in to the residual curve. The correct Inflation index should be selected.
Chapter 7
Economic Costs
Introduction
Economic cost is a wide-ranging area of importance for cost engineers
and cost managers. The project or a product, must be economically feasible to construct or produce. The price of the product is must be in a range that is affordable for its target market. Globalization currency issues, inflation rates, taxation rates, etc. Economic analysis techniques, properly applied, can pinpoint the alternative with the most favorable cost aspects.
Introduction
Economic cost analysis will be performed to study The feasibility of the project. The feasibility of producing a product with in the acceptable price range affordable by the buyer.
Concepts
Cost engineering professionals must make sensible decisions in the
arena of economic costs. Often this task is complicated by the fact that certain elements of these decisions, such as costs, revenues and benefits, occur at different times in the life cycle of a project. For example, manufacturing processes that proved economical over a lengthy period of time may end up at a net negative cost when the downstream costs of hazardous waste clean up are factored into the equation. While no one can peer unerringly into the future, the more effective the analysis of the totality of economic costs is, the better the resulting decisions will be. Taxation Policies, Depreciation rules, Currency Variations, etc.
Types of Costs
Opportunity Cost Sunk Cost Book Cost Incremental Cost
Opportunity Cost
In economics, opportunity cost, or economic cost, is the cost of
something in terms of an opportunity forgone (and the benefits which could be received from that opportunity), or the most valuable forgone alternative (or highest-valued option forgone), i.e. the second best alternative.
For e.g., In building a hospital in a vacant land, the city has forgone the
opportunity to build a sporting center on that land, or a parking lot, or the ability to sell the land to reduce the city's debt.
Note that opportunity cost is not the sum of the available alternatives,
but rather of benefit of the best alternative of them. The land cannot be used for more than one of purposes.
Sunk Costs
In economics and in business decision-making, sunk
costs are costs that have already been incurred and which cannot be recovered to any significant degree. Sunk costs represent funds already spent by virtue of past decisions. Since these expenditures are in the past, by definition, they should not influence current decisions. For E.g., if the owner can derive more value from selling the car than not selling it, it should be sold, regardless of the price paid (sunk cost)
Book Costs
Assets are carried on the firms books at original cost less
any depreciation. Book costs represent the value of an item as reflected in the firms books and it wont reflect the fair market value. Books costs do not represent cash flows and thus are not taken into account for economic analysis decisions except for potential depreciation impacts for tax consequences. Market price for financial assets such as stocks, land values.
Incremental Cost
In
economic analysis decisions, focus must be on incremental costs or those cost differences between alternatives. If we need to compare between two equipments with same annual maintenance fee, there is no incremental difference. Therefore maintenance fee can be excluded from the analysis. But the one equipment annual maintenance is USD 500 more than other equipment, then there is an obvious incremental cost difference, which then must be considered in the analysis between the three alternative units.
Changes in Cost
Changes in costs occur for a number of reasons in
the economy. Cost professionals must be conversant with the potential for cost changes and their implications. The most common cost changes concepts are:
1.
2. 3. 4.
Inflation Deflation Escalation Currency Variation
Inflation
The word inflation refers to a persistent rise in the general price level,
as measured against a standard level of purchasing power. The inflation does not occur by itself but must have a driving force behind it. There are four effects that can result in inflation:

Money Supply influenced by the central bank of a country. Exchange Rates by influencing the price of imported goods & services. Demand-pull Inflation excessive amount of money chasing a limited goods. Cost-push Inflation when product producers encounter higher costs.
Deflation
Deflation is a decrease in the general price level over a
period of time. Deflation is the opposite of inflation. The same driving force of Inflation will cause deflation but in different direction.
Escalation
Escalation is technique to accommodate price increases or decreases
during the life of the contract.

An escalation or de-escalation clause is incorporated into the contract so
that the purchaser will compensate the supplier in the event of price changes.
It will help to shield both the supplier and the purchaser from
unpredictable cost changes.

Without such clauses, suppliers would include contingency amounts. Fixed Price Economical Price Adjustment Factor is a type of contract
where escalation technique will be used.
Currency Variation
Due to the predominant Multi National Companies
who operates in different country and trades are happening across the horizons, currency variation plays a important role in economic cost analysis. For e.g., Financial assets held in one country can go down if the country central bank devaluate the currency. Protecting against currency variation is complicated and can be accomplished through currency futures hedging or valuing contracts against very stable currencies, to cite two examples.
Governmental Cost Impacts

The
actions of the governmental units and jurisdictions can impose significant cost impact on the firm. Taxes, Economic Sanctions, Embargo are some examples of governmental cost impacts to a firm.
Taxes
Governments are most often maintained by the taxes they impose. There are different types of taxes: Income Tax Property Tax Inventory Tax Employment Tax Gross Receipts Tax Sales Tax VAT (Value Added Tax)
Effective Tax Rates and Marginal Tax Rates

Creating
Evaluating
Analysis
Applying
Effective Tax Rates
Actual income tax paid divided by net taxable income before taxes, expressed as a percentage. The tax rate paid on the last dollar of one's income (Tax rate on the next dollar of taxable income).
Marginal Tax Rates
Investment Tax Credits

To
encourage investment or economic activity, governments may give firms tax credits based on their investments in a particular location. Government may want to encourage the location of new plants in economically depressed areas and, therefore, promote this through investment tax credits including abeyance on certain taxes such as property taxes. JAFZA (Corporate taxes are not applicable for a period of 50 years ) Investment on Non-conventional energy sources.
Depreciation and Depletion

To encourage firms to invest in new plants and machinery, government often
allow firms to depreciate their investment over time. Thus depreciation technique will allow the firm to reduce its income by a set proportion per year with a depreciation write-off until the investment is fully depreciated. The limits on investment depreciation write-off are prescribed by the governmental tax code. Depreciation thus should be not confused as s cash-flow, but rather an non-cash expense that reduce taxable income. Firms are allowed to depreciate based on original plant and equipment costs. Current and future inflation during the assets depreciation can not be taken into account for these purposes.
Depletion
Depletion is comparable to depreciation but it is used
for natural resources. Owners of natural resources like quarry, oil well, or standing timber as examples can take depletion allowances based on the percentage of resources used up in a given time period.
Depreciation Technique
Standard Methods Straight-Line (SL) method Double-Declining Balance (DDB) method Sum-Of-Years Digits (SOYD) method Modified Accelerated Cost Recovery System (MACRS) Units Of Production (UOP) method
Straight Line Depreciation

Simple Method equal amount of depreciation every
year.
Formula is D = (C-S) / N D = Depreciation Charge C = Asset Original Cost S = Salvage Value, and N = Asset Depreciable Life
Exercise: Find Depreciation Charge for an asset
original cost $10,000, 5-years life and $2900 residual salvage value.
Double-Declining Balance Depreciation

It applies constant depreciation rate to the assets
declining value.
Formula is D = (2/N) (C-BVt-1) D = Depreciation Charge C = Asset Original Cost BV = Book Value at given Year, and N = Asset Depreciation Life (Years)
DDB: Asset $10,000, 5 Years, $2900 Residual Value

Creating Year 1 2 3 4 5 Evaluating DDB Formula (2/5)($10000-0) (2/5)($10000-$4000) (2/5)($10,000-$6400) (2/5)($10,000-$7840) (2/5)($10,000-$8704) Total Analysis Applying Understanding Remembering DDB Allowable Depreciation $4000 $2400 $700* $0 $0 $7100 DDB Calculated Amount $4000 $2400 $1440 $864 $518 $9222
* An asset cannot be depreciated below its salvage value thus depreciation
Sum-of-Years Digits Depreciation

SOYD method allows depreciation to be taken at a faster rate than Straight Line
Depreciation.
SOYD method takes depreciation in any one year as the product of a fractional
value times the total original depreciable value.

Formula is Dr = (C S) * [(2 ( N r + 1 )) / (N ( N + 1 )) ] Dr = depreciation charge for the rth year C = asset original cost S = Salvage value N = remaining asset depreciable life (years) r = rth Year
SOYD Amount
Year
SOYD Formula
SOYD Calculated Amount
1
2 3 4 5
(5/15)($10,000-$2900)
(4/15)($10,000-$2900) (3/15)($10,000-$2900) (2/15)($10,000-$2900) (1/15)($10,000-$2900) Total
$2367
$1893 $1420 $ 947 $ 473 $ 7100
Modified Accelerated Cost Recovery System

The MACRS is unique to United States Tax Code.
Depreciation under this MACRS method is based on original asset cost, asset class, asset recovery period and asset in service date. Asset classes are differentiated based on 3-year, 5-year, 7-year, 10-year and other property lives, depending on asset type. Depreciation rates are set by percentages allowed under U. S. Tax Code.
Units of Production Depreciation

The UOP method is utilized when depreciation is more accurately based
on usage instead of time. The UOP method is particularly useful when an asset encounters variable demand. A piece of construction equipment may be used:

First Year 1200 Hrs Second Year 2400 Hrs Third Year 600 Hrs
The UOP method recognizes that the equipment wears out based on use
and, therefore, is a more accurate barometer than years.
Economic Analysis Techniques

1. 2. 3. 4. 5. 6.
There are a variety of economic analysis techniques available to enable accurate choices between competing alternatives. They are: Net present worth Capitalized cost Annual cash flow analysis Rate of return analysis Benefit-cost ratio analysis, and Payback period
Time Value of Money

Creating

Evaluating
Analysis
Applying
The time value of money is a key area in economic cost analysis. The time value of money is the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. Common language terms

P = Present Value or present worth F = Future Value or future worth A = Annual amount or annuity G = Uniform gradient amount n = number of compounding periods or asset life I = Interest value S = Salvage Value
Net present worth method

A common basis is needed when comparing alternatives.
Alternatives typically will have different costs and benefits over the analysis period. The net present worth (NPW) method provides the platform to resolve alternatives into equivalent present consequences.
A firm is evaluating the potential purchase of one of two pieces of equipment. Unit A has a purchase price of $10,000 with a four-year life and zero salvage value. Annual maintenance costs are $500 per year. Unit B has a purchase price of $20,000 with a twelve-year life and $5,000 salvage value. In Year 1, maintenance costs are zero. In Year 2, maintenance costs are $100 and increase by $100 per year thereafter. The firms cost of capital is 8%.
Net present worth method

Creating
Evaluating
Analysis
Applying
NPW Unit A:

= $10,000 + $10,000(P/F,8%,4) + $10,000(P/F,8%,8) + $500 (P/A,8%,12) = $10,000 + $10,000(0.7350) + $10,000(0.5403) + $500 (7.536) = $26,521 = $20,000 + $100(P/G,8%,12) + $5,000(P/F,8%,12) - $100 = $20,000 + $100(34.634) + $5,000(0.3971) - $100 = $21,349 Analyzing costs, lower NPW Unit B is preferable. Analyzing benefits, higher NPW Unit A is preferable.
NPW Unit B:

Capitalized Cost Method

Capitalized cost represents the present sum of money
that needs to be set aside now, at some interest rate, to yield the funds required to provide the service indefinitely. Formula is A=PI
A bridge is build for $10,000,000 and will have maintenance cost of $200,000 per year. At 6 percent interest, what is the capitalized cost of perpetual service?

Present Value = $10,000,000 Ongoing cost = $200,000 Capitalized Cost = $10,000,000 + ($200,000)/.06 = 13,333,333
Equivalent Uniform Annual Cost or Benefit

Creating
Evaluating
Analysis
Applying
For some types of analysis, it may be preferable to resolve the comparison to annual cash flow analysis. The comparison may be made on the basis of equivalent uniform annual cost (EUAC), equivalent uniform annual benefit (EUAB) or on the EUAB-AUAC difference. Annualized sum of all relevant costs. It is like the amount of an installment loan payment. Unit A Unit B Initial Cost $20,000 $15,000 Salvage Value $3,000 $2,000 Life Year 10 Years 5 Years Cost of Capital 10% 10%
EUAC Solution
Formula is (P S) (A/P, I, n) + SI EUAC (A) = ($20,000 - $3000) (A/P, 10%, 10) +
3,000(0.10) = ($17,000) (0.1627) + $300 Right Choice = $2765.90 + $300 = $3065.90 EUAC (B) = ($15,000-$2,000) (A/P, 10%, 5) + $2,000(0.10) = ($13,000) (0.2638) + $200 = $3629.40
Rate of Return Analysis

Many organizations in making investment choices
often set hurdle rates. The hurdle rate is the benchmark rate of return that a capital investment decision must achieve to be acceptable. A rate of return (ROR) is computed from the projected cash flows of the project. Rate of return (ROR) or return on investment (ROI), or sometimes just return, is the ratio of money gained or lost on an investment relative to the amount of money invested.
Rate of Return Analysis

Assume that in the comparison between Unit A and Unit B (each with a 1-year life) that the cost of $20,000 for Unit A versus a $10,000 cost for Unit B also results in an incremental benefit of $15,000 for Unit A as compared to Unit B. If the organization has a hurdle rate of 20 percent for capital projects, which alternative a better choice. NPW of the cost is set equal to the NPW of the benefit. The NPW cost of Unit A versus Unit B is $10,000 ($20,000-$10,000). The NPW of the Unit A Unit B benefit is $15,000. ROR NPW Cost = NPW Benefit
$10,000 = $15,000 (P/F,I,1) $10,000/$15,000 = 0.667
Benefit-Cost Ratio Analysis Method

Creating
Evaluating
Analysis
Applying
Benefit Cost (B/C) Ratio analysis involves the simple comparison between benefits and costs of a proposed action. Benefits are placed in the numerator and costs are placed in the denominator. If the ratio of benefits to costs is greater than one, project is viable. Comparisons can be made between projects to select those projects with highest B/C ratio. Its a simple comparison between benefits and costs of a proposed action. For e.g., Project A Project B NPW Benefit $1,500,000 $2,000,000 NPW Cost $1,200,000 $1,700,000 B/C 1.25 1.17 On the basis of the above B/C analysis, both projects A and B have a positive B/C ratio, but Project A would be selected as its 1.25 ratio is greater than the Project Bs 1.17 ratio.
Pay Back Period Method

Payback period in business and economics refers to the
period of time required for the return on an investment to "repay" the sum of the original investment. Very simple method and can prove inaccurate. A project with a payback period of three years may be selected over a similar project of five year pay back period. Differences in the timing of cash flows are not considered nor are benefits and costs beyond the pay back period. For example, a $1000 investment which returned $500 per year would have a two year payback period.
Chapter 8
Activity-Based Cost Management
Introduction
In a business organization, Activity-based costing (ABC)
is a method of allocating costs to products and services. It is generally used as a tool for planning and control. Traditionally cost accountants had arbitrarily added a broad percentage onto the direct costs to allow for the indirect costs. However as the percentages of overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products. Fig 8.1
ABC
More accurate cost management methodology Focuses on indirect costs (overhead) Traces rather than allocates each expense category to
the particular cost object. Makes "indirect" expenses "direct"
ABC Basic Premise

Cost objects consume activities Activities consume resources This consumption of resources is what drives costs Understanding
this relationship successfully managing overhead
is
critical
to
When to use ABC

Overhead is high Products are diverse: complexity, volume, amount of
direct labor Cost of errors are high Competition is stiff
ABC
For example, one product might take more time in
one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
Methodology
Direct labor and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions takes at the counter and then by measuring the number of each type of transaction.
Limitations
Even in activity-based costing, some overhead costs
are difficult to assign to products and customers, for example the chief executive's salary. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed.
ABC Steps
1. Identify activities 2. Determine cost for each activity 3. Determine cost drivers 4. Collect activity data 5. Calculate product cost
1. Identify activities
Set-up Machining Receiving Packing Engineering
2. Determine activity cost

Set-up Machining Receiving Packing Engineering
$10,000 $40,000 $10,000 $10,000 $30,000
3. Determine Cost Drivers

Set-up: Machining Receiving Packing Engineering
Number of Setups Machining Hours Number of Receipts Number of Deliveries Engineering Hours
4. Collect Activity Data

Activity Setup Machining
Cost 10,000 40,000
Product A 1 100
$ 2,500 2,000
Product B $ 3 1900 7,500 38,000
Receiving Packing Engineering
10,000 10,000 30,000
1 1 500
2,500 2,500 15,000

24,500
3 3 500
7,500 7,500 15,000

75,500
Product Cost Calculation
Creating
Evaluating
Analysis
Applying
Overhead for Product A: $24,500:100 = $245 Overhead for Product B: $75,500:1900 = $ 39.74
Product Cost TCA vs. ABC

Creating

Evaluating
Analysis
Applying
Cost for Product A: Overhead: Direct Cost Total Cost for Product B: Overhead: Direct Cost: Total TCA: $50.00 $20.00 $70.00 ABC: $245.00 $20.00 $265.00
TCA: $100.00 $40.00 $140.00
ABC:
$39.74 $40.00
$79.74
ABC vs. TCA

ABC is more accurate cost management system than
Traditional Cost Accounting Traditional Cost Accounting is unable to calculate the "true" cost of a product
Creating
Evaluating
Analysis
Applying
END OF SECTION 1

Section1 Cost

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COST

Material Labor Other

Cost structuring will help to get clear picture of

Cost Structuring: Direct Costs

The cost which is expended solely for the purpose

Cost Structuring: Indirect Costs

Indirect costs are costs that are not directly

Cost Structuring: Fixed Costs

Fixed costs are expenses whose total does not

Cost Structuring: Variable Costs

Code of Accounts / Chart of Accounts

Based on the business practices, organization uses

Code of Accounts / WBS

Code of Accounts for projects will be generally

based on Work Breakdown Structure numbering system.

Cost element and Cost structuring will be useful for

Cost Estimating Cost Trending Cost Forecasting Life-Cycle Costing

Discussed in detail in later sessions

Cost Estimating predicts the resource requirement

A clear scope Cost element structure Historical information / Expert judgment

Cost trending uses historical information as a basis

Estimating focuses on estimating future activities

Cost vs. Pricing

Tools & Techniques of Pricing

Pricing strategies should be based on the given

Type I acquisition is to win the project and perform

Rate of Return (ROR) or Return on Investment

ROI, also called as DUPONT or Engineers method

Other ROI Metrics

Break Even Analysis

The break even point for a product is the point

Selling Price Each unit price which it is sold for

Variable Costs Varies in proportionate with volume

Units The number of items sold or produced

Break Even Unit X = FC / (SP-VC) or X = FC / CM

Break Even Revenue Break-even revenue = Break-even units X SP

Materials are key substances used as inputs for

Materials Handling Equ

Materials Handling Principles

Materials Handling Decision Factors

While we take decisions on materials handling,

the following are the four factors to be considered:

1. Raw Materials (minimum processing e.g..

It requires minimum amount of processing.

material or Engineered/Designed Materials

It requires substantial work in order to achieve its

Production materials purchase and management

To complete an activity or to build an asset, we

Production materials purchase and management

Materials quality management is handled through

It is very important to consider the various factors

Economic Order Quantity - EOQ

D = Annual Demand P = Purchase Order Cost S = Storage / Carrying Cost

A garden tractor manufacturer has a requirement for 15,000 engines

EOQ = [ (2 x D x P) / S] D = 15000 P= 250 S = 12 EOQ = 790

Assume that the production processes uses 60

RP = (5 x 60) + 180 = 480 Units

Just-In-Time Inventory Technique

Individual purchase orders and systems contract

Customized and costly materials purchase needs to go

The purpose of expediting is to ensure that the

Plant Materials Management

There are not part of final product objective but