ENGINEERING MANAGEMENT 302 - 1 -

2
nd
Semester, 2014

ENGINEERING MANAGEMENT 302
LECTURES 1-4

BASIC PRINCIPLES of MANAGEMENT

NOTE: Some definitions and descriptive material are taken from the Web and other
sources to maintain consistency with the terms in line with the business and
management disciplines. They are referenced appropriately.

Manager is person controls and administers all or part of an organisation. Managers achieve
goals through other people.

Management is getting people together to achieve goals and objectives of an organisation
effectively within the available resources.

Organizations: A consciously coordinated social unit functioning to achieve common goals.

Functions of managers

According to Henry Fayol managers:

Forecast: Work out the necessary steps
Plan: defining goals, establishing strategy, and coordinate activities
Organise: determine and allocate tasks, report, open communication channels, and
make decisions.
Staffing: make sure tasks are executed
Lead: motivate, determine directions, resolve conflicts, and set examples.
Control Monitoring activities to ensure that they executed as planned, accomplished on
time, and deviations are corrected.

http://www.youtube.com/watch?v=yhcrOLQjAFI

Power: the capacity of a person to influence the behaviour of others so that others do things
they would not normally do. Power is attained through the control of important resources.

Types of power: FRENCH and RAVEN argue that there are six types of power

1. Reward: based on positive benefits
2. Legitimate: based on the formal position, experience and status
3. Coercive: based on fear
4. Persuasive: based on the ability to allocate symbolic rewards
5. Expert: based on the ability to control unique and valuable information
6. Referent: based on admiration

Power tactics are the translation of power basis to specific action. There are seven commonly
used tactics

Legitimacy: imposing organisation policies and rules
Persuasion: presenting positive argument
ENGINEERING MANAGEMENT 302 - 2 -

Consultation: seeking support
Exchange: target mutual benefits
Assertiveness: use of direct and forceful approach, ordering, enforcing compliance
Coalition: getting the support of others
Sanctions: punishment denying the rights of persons, and so on.

MOTIVATION

Motivation: The willingness to exert high level of efforts towards organisational goals.

Motivation and Hierarchy of Needs

MASLOW formulated the theory of motivation as hierarchy of needs in five stages, Figure 1.1:


















Figure 1.1 Maslows hierarchy of needs

Self-actualisation: creative and challenging work
Esteem: self-respect, autonomy, recognition, responsibility
Social: affection, belongingness, acceptance, and friendship
Safety: protection from physical and emotional harm, job security, compensation
Physiological: physical comfort, reasonable work hours

Other theories such as motivation-hygiene theory, cognitive evaluation theory, etc.

Motivation and Personality

McGREGOR proposes X-type (-ve) or Y-type (+ve), known as the theory X and theory Y.

X-types are:
1. People inherently dislike work and whenever possible they avoid it
2. Since they dislike work they must be coerced, and controlled
3. They will avoid responsibilities and seek formalities whenever possible

Y-types are:
1. Employees view work as a natural part of their living and exercise self-direction and control
3. They accept and seek responsibility
4. They seek innovative ideas.
Physiological needs
Social/Affiliation needs
Safety/Security needs
Esteem needs
Self-
actualisation
ENGINEERING MANAGEMENT 302 - 3 -

http://education-portal.com/academy/lesson/henri-fayols-management-principles-managing-
departmental-task-organization.html

http://education-portal.com/academy/lesson/managerial-skills-how-good-managers-promote-
productivity.html

http://education-portal.com/academy/lesson/theory-x-theory-y-two-types-of-managers.html

http://education-portal.com/academy/course/principles-of-management-course.html

Business 101

TEAM DEVELOPMENT

Team consists of two or more individuals to achieve some goals.

Stages of team formation: has five stages, known as the five- stage group model

1. Forming: teams are formed to accomplish a shared purpose. There are uncertainties
on purpose, structure and leadership.
2. Storming: there is resistance to constraints imposed on individuals. Disagreements on
mission and approaches.
3. Norming: Close understanding and relationships develop for cohesiveness. The group
structure solidifies. There is common expectation about members behaviour.
4. Performing: Group structure is fully functional. The group energy is diverted to
execute the task in hand.
5. Transforming or Ending: tasks are completed.

Team Development Situational Leadership

There is close link between success of the team and leadership, shown in Figure 1.2.




















Figure 1.2 the situational leadership chart

(
H
i
g
h
)

S
u
p
p
o
r
t
i
v
e

B
e
h
a
v
i
o
u
r

L
o
w
)

(Low) Directive Behaviour (High)
High Directive
&
Low
Supportive
Low Supportive
&
Low Directive
High Directive
&
High Supportive
High Supportive
&
Low Directional

Delegating
Coaching
Directing
Supporting
ENGINEERING MANAGEMENT 302 - 4 -

Personality characteristics of team members: team productivity is influenced by morale
and cohesiveness of the members. Other traits such as sociability, self-reliance, independence,
willingness to contribute, responsiveness and respect to the rights of others are essential.


ORGANISING TEAMS

Teams have structure that shapes the behaviour of members by having leadership, roles,
norms, team status and size, and composition.

Leadership: Every team tend to have a leader, such as department managers, supervisors,
foremen, project leader, committee chair, and so on. There are many different types
of leaderships. Participative leadership appears to be more effective than autocratic
leadership.
Roles: A role is defined as a set of expected behaviour patterns attributed to someone
occupying a given position. Roles are shaped by role identity, which is described by
certain attitudes and behaviours consistent with a role.

Despite the role identity individuals have their own role perception. That is, an
individual's view of how he or she is supposed to perform. Role perceptions are shaped
by personality, traits of individuals, and environment.

Role expectation: is how others believe a person should act in a given situation. For
example, a football coach is generally expected to be aggressive, dynamic and
inspiring, although the opposite appears to work equally well.

There is an unwritten psychological contract among team members among
themselves, and management. For example, manager should treat team members
justly, provide good conditions, and communicate clearly. Team members are
expected to demonstrate good attitude, follow directions, and perform as required.

Role conflict can arise if a member is confronted with divergent role expectations. In
some situations, the roles may be mutually contradictory among the members.

Norms: Acceptable standards of behaviour within a team, shared by all. Formal norms are
written by the organizations. I nformal norms are set the by teams telling members
what they can (cannot) do. Norms can:

Facilitate team survival
Increase predictability of member behaviour
Decrease conflict
Allow members to express core values.

Norms develop gradually as members learn what behaviours are necessary for
effective operations. In some cases, teams may have to make explicit statements
about expected norms.

Size: the size of team can affect the overall behaviour. For example, smaller teams can
complete a task quicker; lager ones can have diverse inputs.

Size of team creates Social Loafing: "the tendency of team members to do less than
their individual capability, resulting in an inverse relationship between team size and
individual performance". There are many reasons for social loafing, such as:
http://www.youtube.com/watch?v=Oww-ozL6I_c
http://www.youtube.com/watch?v=zgvBae4AWvk
ENGINEERING MANAGEMENT 302 - 5 -

Belief that other members are not doing enough
Seeing others (or being) lazy and inept
Dispersion of responsibilities
Non-measurability of contributions each member makes.

Composition: Most groups require variety of skills. A heterogeneous group will have diverse
abilities, opinions, personalities, skills, and information, hence can be more effective

http://www.youtube.com/watch?v=FJVS__j_lio&list=PL20A54F1DF4CCC2AD
http://www.youtube.com/watch?v=EJNWE6PDqak

http://www.youtube.com/watch?v=Kj9hw0ngPJU

COMMUNICATIONS MANAGEMENT

Communication fundamentals are illustrated in Figure 1.3.

Elements of communication management are:

1. Communications planning: assembling, distributing, and updating information
2. Information distribution: must be timely and effective
3. Performance reporting: current status, progress made, and forecasting






















Figure 1.3 Communication fundamentals

ORGANIZATIONS

Organizations: A coordinated social entity with collective goal linked to external environment.

Organizations types:
Governments and non-governmental organizations
International organizations
Corporations
COMMUNICATION PROCESS
Idea Encoding
Idea
Decoding Meaning
Encoding
Decoding Meaning
Message
initiated
Message
feedback
Shared experiences
Distraction, interference, words,
culture, judgements, emotions,
personalities, interests, values,
ENGINEERING MANAGEMENT 302 - 6 -

Non-profit corporations
Partnerships
Cooperatives
Public sectors
ORGANIZATIONAL STRUCTURE

Organisational structures are defined by: Complexity, formalisation, and centralisation

1. Complexity is the degree of vertical, horizontal, and spatial differentiation
2. Formalisation is how processes are standardised. High formalisation can give
consistent and uniform outputs. Low formalisation can give greater freedom.
3. Centralisation: In centralised organizations decisions are made by top management.
In decentralised organizations decisions can be taken locally by teams.

There are four basic types of structures:
Departmentalised and Pyramid structures (bureaucratic and hierarchical)
Organic and Matrix structures (no bosses or multiple bosses)
Ecologies (competition within the organisation)
Committees (formed by peers)

DEPARTMENTALISED STRUCTURES: Classical theorists argued that activities in an
organization are grouped into departments.

Functional departmentalisation: is based on group activities by functions performed, e.g.,
engineering, accounting, manufacturing, HR, etc., in Figure 1.5. This can lead to economies
of scale by placing people with common skills in groups.









Figure 1.5 Departmentalisation by functions

ORGANI C STRUCTURES has low complexity and formalisation and it is decentralised.
Communication sideways is effective. It involves participation of many in making decisions.
















Departmentalised structures
High horizontal differentiation
Rigid hierarchical relationship
Fixed duties
Formal communication
Centralised authority
Organic structures
Low horizontal differentiation
Easy collaboration
Flexible duties
Low formalisation
Informal communication
Decentralised decision authority
Plant
Manager
Human resources Manufacturing
Accounting Engineering
ENGINEERING MANAGEMENT 302 - 7 -




Figure 1.6 Organization structures

ORGANISATIONAL SPAN OF CONTROL

Span of control is the number of subordinates a manger can control.
















Figure 1.4 Span of control

Classical theorists prefer small span, no more than 6. Wider or larger the span the more
efficient the organization becomes economically, as illustrated in Figure 1.4.

Note: Research indicates that in many cases jobs may be highly technical and specialised. This
may create a gap between the authority and employee. Since managers may not be
competent in these jobs they rely on authority to exercise their power, which can result in less
satisfied employees.

http://www.youtube.com/watch?v=STED8sSHJU8

http://www.youtube.com/watch?v=wtMORWO5h9Y

http://www.youtube.com/watch?v=R-m8grawp1k

ORGANISATIONAL CHANGES

Organisations select structures and implement changes for:
1. Strategy
2. Organization size
3. Technology
4. Environment
5. Power-Control

STRATEGY

CHANDLER suggests that as the organization grows they get more ambitious and their
products diversify, thus making periodical restructuring essential. Strategy theory suggests
that organizations go through restructure for three reasons:

1
4
16
64
256
1,024
4,096
1
8
64
512
4,096
Span of 8
4,096 Operatives
585 Managers
Span of 4
4,096 Operatives
1,365 Managers
ENGINEERING MANAGEMENT 302 - 8 -

1) Innovation
2) Cost minimisations
3) Imitation

1. Innovation IS the introduction of major new products and services. Organic structure
is suitable since it is flexible, low division of labour, and low formalisation.
2. Cost minimisation emphasizes tight cost control. Departmentalised structure is
suitable since it has tight control and high formalisation.
3. Imitation strategy emphasizes to move into new products or new markets only after
their viability has been already proven.

ORGANIZATION SIZE

The number of people employed in an organization can determine the type of structure.

TECHNOLOGY

Organizations transfer inputs to outputs by: unit production, mass production, and process
production.

Management in unit production has low vertical differentiation; low horizontal differentiation,
and low formalisation, therefore organic structure is suitable.

Management in mass production has moderate vertical differentiation, high horizontal
differentiation, and high formalisation, therefore mechanistic structure is suitable.

Management in process production has high vertical differentiation, low horizontal
differentiation, and low formalisation, therefore organic structure is suitable.

ENVIRONMENT

Environmental factors inside and outside of an organisation strongly affect its performance.

EMERY and TRIST identify four kinds of business environments

1. Placid-randomised environment in which demands are randomly distributed and
changes occur slowly such as the farming organisations.
2. Placid-clustered environment in which changes occur slowly but threats occur in
clusters such as the mining industry. Organization must have long range strategic plan
and centralised decision making.
3. Disturbed-reactive environment in which environment is dominated by one or more
large organizations. Examples are computer industries, automobile industry, etc.
4. Turbulent-field environment in which environment changes constantly such as the
stock exchange, most electronics and software industries.

http://www.youtube.com/watch?v=3Jk6clmMycI

ETHICS

Ethics is a general term for what is often described as the "science (study) of morality". In
philosophy, ethical behaviour is that which is "good" or "right." The Western tradition of ethics
is sometimes called moral philosophy. This is one part of value theory (axiology) the other
part is aesthetics one of the four major branches of philosophy, alongside metaphysics,
epistemology, and logic
ENGINEERING MANAGEMENT 302 - 9 -

(http://www.google.com.au/search?hl=en&defl=en&q=define:ethics&sa=X&oi=glossary_defini
tion&ct=title )

Values are those things that really matter to each of us ... the ideas and beliefs we hold as
special. Caring for others, for example, is a value; so is the freedom to express our opinions."

"Ethics deals with what we believe to be good or bad and with the moral obligations that these
beliefs imply. Ethics involves the rules for deciding right and wrong and the code of conduct
that is based on our decisions. While there are some things that not everybody sees eye-to-
eye with in this area, there are a whole lot more that we do agree about. For example, to steal
is wrong, for most of us. So too is physical assault. Most of us don't think it is right to cheat in
school; many of us think it is injustice to punish someone who didn't do anything wrong. As an
idea, ethics is simple, but the consequences re profound!"
(http://www.ethicscommittee.ca/definition-of-ethics.php )

Responsibilities of Engineers

Engineers have a responsibility to act in an ethical and responsible manner in all their
professional dealings. Essentially we are required to act in a rational and objective manner
that is transparent and easily defendable

Ethical & Philosophical Dilemmas

Many projects involve subjective decision making that may result in an outcome that is not
consistent with a persons own values, but which protect the companies interests. These
decisions can best be viewed in three categories:

Environmental Dilemmas e.g., pollution
Social Dilemmas, e.g., adverse impacts on local communities
Commercial / Contractual Dilemmas

Different Countries Different Ethical Values

AUSTRALIA
Companies operating in Australia must comply with Australian laws and regulations, on:
Environmental Management issues, and
Social Responsibilities
Australian Companies operating abroad
Obey the local laws
Avoid potential abuse of power

Conclusions for ethical behaviour in Engineering

Engineers must act in a rational, objective, transparent, and defensible manner
Engineers engaged in Project Management must understand ethical issues and make
judgements objectively
Reputable companies do not place Engineers in ethically compromising situations
IEEE Code of Ethics (2006)
We, the members of the IEEE, in recognition of the importance of our technologies in affecting
the quality of life throughout the world, and in accepting a personal obligation to our
profession, its members and the communities we serve, do hereby commit ourselves to the
highest ethical and professional conduct and agree:
ENGINEERING MANAGEMENT 302 - 10 -

1. To accept responsibility in making decisions consistent with the safety, health and welfare
of the public, and to disclose promptly factors that might endanger the public or the
environment;
2. To avoid real or perceived conflicts of interest whenever possible, and to disclose them to
affected parties when they do exist;
3. To be honest and realistic in stating claims or estimates based on available data;
4. To reject bribery in all its forms;
5. To improve the understanding of technology, its appropriate application, and potential
consequences;
6. To maintain and improve our technical competence and to undertake technological tasks
for others only if qualified by training or experience, or after full disclosure of pertinent
limitations;
7. To seek, accept, and offer honest criticism of technical work, to acknowledge and correct
errors, and to credit properly the contributions of others;
8. To treat fairly all persons regardless of such factors as race, religion, gender, disability,
age, or national origin;
9. To avoid injuring others, their property, reputation, or employment by false action;
10. To assist colleagues and co-workers in their professional development and to support them
in following this code of ethics.
Download a copy of the IEEE Code of Ethics (PDF)
Source: http://www.ieee.org/portal/cms_docs/about/CoE_poster.pdf
http://www.youtube.com/watch?v=n9A8-FjhArE
http://www.youtube.com/watch?v=r4HrtcSwpVE
ENGINEERING MANAGEMENT 302 - 11 -

BASIC PRINCIPLES of ENGINEERING ECONOMICS

DEFINITIONS

Economics is a social science that deals with the production, allocation, and use of goods and
services. www.wordnet.princeton.edu/perl/webwn

There are many different ways to look at economics: classical economics, Keynesian
economics, political economics, labour economics, evolutionary economics, and many others.
In this course we will largely be dealing with microeconomics.

Macroeconomics: the study of the entire systems of economics. It deals with growth,
inflation, unemployment, monetary and fiscal policies, national income, and long term
economic considerations http://www.investopedia.com/terms/m/microeconomics.asp .

Microeconomics: the study of individual units that make up the whole economy. It studies
how individual markets and industries organised, patters of competition, and economic
efficiency. It concentrates on consumers, households, and firms; how prices are determined;
price/production relations; distribution, and the use of goods and services.

Supply: the amount of goods or services available at a given price at any time.

Demand: how many consumers desire to consume the goods or services that are in supply.

Goods: can be described as tangible items for consumption. There are many types: consumer
goods; producer goods e.g., raw materials; capital goods e.g., machinery.

Services: helpful or professional activities performed as duties or work for others, such as
education, health, communications, transportation, banking, social services, and tourism.

I ndustry: a sector of economy made up of different categories of businesses. Examples are:
Aerospace, health care, automobile, entertainment, defence, technology, manufacturing,
farming, tourism, energy, finance, and building and construction.

Gross domestic product, GDP: the dollar value of all the final value of goods and services
produced in a country. If the real GDP goes down, we say economy is in state of recession.
Severe recession is depression.
http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)
http://en.wikipedia.org/wiki/List_of_countries_by_past_and_future_GDP_(nominal)_per_capita

Economic policy is concerned with finding solutions to economic problems. It is based on
cultural, social, legal, and political issues. Major economic policies are: price stability,
employment, economic growth, environmental standards, economic freedom, tax burdens,
income distribution, and balance of trades.

I nflation is a continuing general rise in prices.

Monopoly is a market structure in which entire market for a good or service is supplied by a
single seller or firm. In this case a firm is said to have monopoly power if it is able to set prices
with no close possible substitutes in the market.

Oligopoly is a market condition dominated by a few large firms.

Perfect competition is a condition that many firms compete in the market.
ENGINEERING MANAGEMENT 302 - 12 -


BRIEF HISTORY of ECONOMIC THEORY

Economics went through many phases throughout the history. First structured ideas about
economics started during the ancient Greek civilisation. Todays ideas and practices are based
on studies and theories of many well-known economists, such as

Adam Smiths were ideas expressed in book The Wealth of Nations 1776. This started the
modern economic outlooks.

Thomas Malthus (19
th
century) expressed that population would always advance faster than
science and technology.

David Ricardo (19
th
century) put forward ideas about wages and labour relationship. To be
elaborated by Karl Marx and others.

John Stuart Mill (19
th
century) talked about cooperatives and labour unions, and competition.

John Maynard Keynes (early 20
th
century) wrote about business cycles. His ideas welcomed by
governments to exercise more controls on their economies.

Milton Friedman (late 20
th
century) put forward theories on the money supply, which is the
most important influence on todays economy.

http://www.bloomberg.com/video/77542270-author-frank-discusses-economic-theory.html

SUPPLY AND DEMAND

The supply and demand model describes how prices vary as a result of the balance between
available products and the demand for them as in Figure 1.1.
















Figure 1.1 The Supply and Demand curve

Demand is the quantity that all prospective buyers would be prepared to purchase at each
unit price of the goods and services. The law of demand asserts that the lower the price
charged for a good the larger the demand. There a many determinants of demand, such as the
price of all other goods, household incomes, expectations, tastes and the numbers of buyers.
Changes in any of these will result a shift in the demand curve to go up or down, right or left
as in Figure 1.1.

Quantity
P
r
i
c
e

Q
1
Q
2
P
2
P
1
D
1
D
2
S
ENGINEERING MANAGEMENT 302 - 13 -

Supply is the relationship between the quantity of a goods and/or services that producers are
willing to bring into the market. Supply is determined by: the prices of resources, technology,
number of suppliers, and supplier expectations.

Changes in supply and demand, represents by shifts in curves that will upset the equilibrium.
This sets in motion competitive price bidding which eventually results in a new equilibrium. The
basic supply and demand curve in Figure 1.1 gets much more complex as other factors
affecting the economy comes into play.

Economy also depends on other factors such as consumer confidence, spending and profits,
prices, investments, income, and future expectations. Keynes pointed out that the economy
needs to have continuous investment for growth - otherwise a Depression, like the one in early
1930s, will take place. The 1930s depression is depicted in Figure 1.2.


















Figure 1.2 Reasons and effects of 1930s economic depression

http://www.youtube.com/watch?v=2YyJWEzY0vo
http://www.youtube.com/watch?v=nyAZGqFtVjw

ENGINEERING ECONOMICS

Engineering economics is a branch of economics for the application of economic methods in
the engineering operations, projects, supply of goods and services. It is related to
microeconomics but macroeconomics involved.

Some other topics of engineering economics are: financial statements, accounting, inflation,
depreciation, resource depletion, taxes and effects of taxes, cost estimation and behavior,
capital financing, time value of money, money management, cash flow, etc. In addition there
are non-economic considerations such as product safety, environmental factors, public image,
etc. www.answers.com/topic/engineering-economy

Engineers are involved in decision making process related to engineering economic. Therefore
all engineers should be aware of how the businesses are run, how the decisions are taken as
well as implications of those decisions for the present and future operations of the companies.

The successes of companies are also shaped by many internal and external factors as shown in
Figure 1.3.
Stock Market Crash on
29
th
Oct 1929:
Consumer
confidence
Down 25% in 2 days
Down 40% in 2 months
Wealth
Spending &
profits
Prices
Future
expectations of
prices & profits
Investment
Income
In 2.5 years the US
S&P Index lost 89%
adding further fuel to
the Depression
ENGINEERING MANAGEMENT 302 - 14 -

















Figure 1.3 Importance of engineering economics

Many companies need to take up new projects and require large sums of upfront investment,
which are difficulty in forecasting revenues and costs. An investment process is depicted in
Figure 1.4.











http://www.youtube.com/watch?v=UMYLvEuzYUI

ACCOUNTING

Accounting is a process of recording, summarizing, and allocating all items of income and
expense of a company and analysing, verifying, and reporting the results.

Accounting is required to measure how well the economic objectives in an organization are
achieved. It provides data to indicate financial performance and assessing future directions.

Economic objective of many companies is to maximize the profit, that is:




Purpose of Accounting

Internal reporting for cost planning, control and performance evaluation
Internal reporting for recourse allocation and pricing
Internal reporting for decisions, long term plans, new products, and investments
External reporting to shareholders, creditors, and governments
Investment
Design &
Planning
Marketing
Product
Manufacturing Profit
Figure 1.4 Investment process
Profit = Revenue - Expenses
Innovations &
production
Dynamic business
environment
Investments & value
of dollar
Technology and
advancements
Risk management &
measuring
Social & external
demands & constraints
Engineering
Economics
ENGINEERING MANAGEMENT 302 - 15 -


Ethical Aspects of Accounting

Accounting requires good Ethical practices, such as:

Integrity, sincerity and honesty
Objectivity and impartiality
Confidentiality and independence without conflict of interest
Professional conducts and high competency

TYPES OF ACCOUNTING

Financial Accounting (for external purpose)
Managerial Accounting (for internal purpose)
Cost Accounting (management accounting + financial accounting)

1. Financial Accounting

Financial Accounting is a way of reporting of the financial position and performance of a
company through financial statements issued periodically.

Financial Accounting reports are used by shareholders, banks, regulators, etc. It is past
oriented and constrained by law. It must be accurate.

2. Managerial Accounting

It uses both historical and estimated data in providing information for management. It is used
in daily operations, and planning future operations. It helps developing business strategies.

It is less accurate compared to financial accounting. It uses data deemed to be relevant for
internal use and decision making by managers. It is generated either regularly or ad hoc basis
to estimate near or long term future performance and revenues.

3. Cost Accounting

Cost accounting is used for estimating, tracking and controlling product and service costs. It is
practiced for internal reporting for cost control, performance evaluation, and profitability. The
reports may be used for external reporting such as financial statements, shareholders, bank
reports, and taxation office.

COST ACCOUNTING

CLASSIFICATION

Costs can be classified as

1. Assignment of costs to a cost object
a. Direct costs
b. Indirect costs

2. Profit determination
a. Capitalised costs: expenses in financing fixed assets
b. Product costs
c. Overhead costs
ENGINEERING MANAGEMENT 302 - 16 -


3. Changes in cost drivers
a. Variable costs
b. Fixed costs

Example// Manufacturing industry will have: direct material costs, direct manufacturing labour
costs, manufacturing overhead costs.






















COST TERMINOLOGY

Cost accumulation: is the collection of cost data in an organised manner.

Cost assignment: is the assignment of accumulated cost to cost objects.

Cost Object: is a tangible input for a product/service.

Direct cost: is a cost that can be directly traced to specific products/services.

Indirect cost: is any cost incurred for common objectives and therefore cannot be directly
charged to any single cost objective. Indirect cost is also termed overhead or burden cost.

Value Chain is adding value through various processes. Value added through R & D, design,
production, distribution, and customer services.

Prime cost is the total cost of direct materials, direct labour and direct expenses.

Conversion cost is the cost to process material in a single stage, from one type to another.

Marginal Revenue is the extra revenue that an additional unit of product will generate.

Marginal Cost is the change in total cost when one extra unit is produced.

Sunk Cost is the cost incurred in the past, and is not relevant for to future decisions. In
software engineering, digital products usually have significant sunk costs in the form of R&D,
Direct material cost
Beginning $11,000
New purchases 73,000
Cost of material available 84,000
Ending material 8,000
Direct material used 76,000

Direct manufacturing labor 17,500

Manufacturing overhead costs
Indirect labor 4,000
Other supplies 1,000
Electricity 2,000
Depreciation of plant 1,500
Depreciation equipment 2,500
Miscellaneous 500 11,500

Total manufacturing cost 105,000
ENGINEERING MANAGEMENT 302 - 17 -

intellectual property, patents, etc. If the product is not successful, the costs associated with
that product cannot be recovered.

Opportunity Cost is the potential benefit given up as by an alternative course of action.

Inventory is a complete listing of the type amount and value of assets owned by a company
at a point in time (e.g. July 1). Inventory is the tangible finished products waiting to be sold
and/or direct materials to be processed. There are three major types of inventories:

Raw materials inventory
Work in process inventory
Finished goods inventory

In the inventory stage, the manufacturing costs are treated as assets. Inventory becomes an
expense only when sold once sold they are treated as costs of goods sold.

There are two fundamental ways of accounting for inventories:

1. Perpetual inventory based on continuous monitoring on real-time.
2. Periodic inventory accounting for inventory at the end of a specified period.

Costing System is an accounting system for monitoring a company's costs. By
collecting data, cost assignment, tracing, and allocation of costs by the following steps:

Step 1 The costs are recorded as assets when costs incur. The costs are recorded as
expenses when the revenue is generated associated to that cost.

Step 2 Product costs are determined. Products are considered as assets until they are
sold. After selling they become expenses.

Step 3 Period costs are deducted as expenses in a relevant period. The period costs can
be: Administration costs, marketing costs, advertising and distribution costs, etc.


COST DRIVERS

Cost Driver is any activity that causes costs to incur. There are two types:

1. Structural cost drivers are due to: strategic choices of an organization, its structure,
size, complexity, and technology used.

2. Executional cost drivers are due to execution activities, capacity utilization, plant
layout, and work-force involvement.

Cost behaviour is the sensitivity of costs to changes in production. It is influenced by:

1. Fixed costs
2. Variable costs
3. Mixed costs

Fixed Costs is the cost that stays constant over the relevant range, including the rent,
insurance, salaries, depreciation, property taxes, buildings, machinery, and so on. Average
fixed cost per item is reduced by increasing the number products produced, but the total cost
remains fairly constant.

ENGINEERING MANAGEMENT 302 - 18 -

Average Fixed Cost (AFC) is the total fixed costs (TFC) divided by number of units produced.




When number of units produced increases, AFC decreases, known as Economies of Scale.

When companies expand to increase their outputs, the TFC may increase (Figure 1.5) due to:
additional supervision, machinery, buildings, bigger warehouses, and so on. This expansion
depends on company policies, market potential, competitors, and availability of finances.












Figure 1.5 Total Fixed Costs and Average Fixed Costs

Variable cost is the cost that changes directly proportional to the number of units produced.
It includes labour, materials used per unit, sales commission per unit, etc.

Total Variable Cost (TVC) is equal to the number of units produced multiplied by the
variable cost per unit.

Average Variable Cost (AVC) is the cost per unit. AVC is high for low volumes but remains
fairly constant as the number of units increases (Figure 1.6). AVC may be improved by
productivity improvements, new technologies, use of different materials, labor training.










Figure 1.6 Total Variable Cost and Average Variable Cost behavior

Total Cost is sum of the Total Fixed Costs and the Total Variable Costs.



Unit cost is the total cost divided by the number of units produced




The profits are related to cost and revenue, as:
Average Fixed Cost (AFC) = Total Fixed Cost (TFC) / Total Units Produced
Units Produced
Total Variable
Cost
(TVC)
Units Produced
Average
Variable Cost
(AVC)
Units Produced
Total Fixed
Cost (TFC)
Units Produced
Average Fixed
Cost (AFC)
Unit Cost = Total Cost / Number of units produced
Total Cost = Total Variable Cost + Total Fixed Cost
ENGINEERING MANAGEMENT 302 - 19 -




Example// Manufacturing salaries and wages:
















http://www.youtube.com/watch?v=TLYwPogWdEU&list=PL2D96727267C7FD8E

Contribution Margin is the marginal profit per unit sale. It is calculated as the price of the
product minus the total variable cost of that unit. Therefore, the contribution margin can be
thought of as the fraction of sales that contributes to offsetting fixed costs.

For example if a manager determines that a particular product has a 35% contribution margin.
This figure can then be used to determine whether variable costs for that product can be
reduced, or if the price of the end product could be increased for higher revenue.




Unit Contribution Margin is the contribution of each unit sold to cover fixed costs.




Example// Contribution margin:









Break Even Point is the point where the cost is equal to the revenue from products.




Mixed costs contain both fixed and variable elements such as depreciation of machinery.

Contribution margin = Total revenue Total variable costs
Break Even = Quantity of output where Total revenue equals Total cost (zero profit)
Revenue $200100 units $20,000
Variable costs 120100 units 12,000
Contribution margin 80100 units 8,000
Fixed costs 4,000
Profit before tax 4,000
Income tax 1,200
Net Profit 2,800
Unit Contribution Margin = Price per unit - Av Variable Cost per unit
Direct manufacturing labor $20,000
Indirect manufacturing labor 10,000
Sales salaries and commissions 15,000
Administrative salaries and wages 5,000
Total payroll gross 50,000

Withholdings
PAYE tax $15,000
Union dues 1,000
Private health insurance 4,000
Superannuation contribution 2,000
Total withholdings 22,000

Total payroll net 72,000
Profit = Revenue Total costs
ENGINEERING MANAGEMENT 302 - 20 -

PROFIT DRIVER TREE

Profit driver tree (Figure 1.7) summarizes expenses and revenues in terms of fixed and
variable costs, and the prices of units.



















Figure 1.7 Profit driver tree


INDUSTRY COST / SUPPLY CURVES

Industry cost/supply curves show total numbers of suppliers, the cost, volume, and price of
products in a particular marketplace, as in Figure 1.8.




















Figure 1.8 Determination of Costs and Profits for different companies

Each firm chooses the volume of products to produce based on lowest cost point (max profit).

Example// Cost and price curve for alumina production in the world, Figure 1.9a, b and c.
Max (Profi t)
Ave Price / Quantity Sold
Fixed
Costs
Overhead
Marketing
Administration
Variable
Costs
+
Average Variable Cost /
Quantity Produced
Quantity Produced
Revenue
Expenses
Quantity Sold
+
x
-
+
x
Material ($/unit)
Labour ($/unit)
Mfg Overhead
($/unit)
+
+
Average Variable Cost
per Quantity Produced
remains fairly constant
over a given range of
output levels
Total Fixed Cost remains fairly
constant for a large range of
Quantity Produced
NOTE: Engineers are traditionally more
interested in expense, or cost, behaviour NOTE: Its assumed that Quantity Produced is
the only dri ver of cost, or Vol ume Index
Quantity Produced
% Produced sold
x
Requires understanding from
Marketing & Economics not
covered in this course

Units Produced
Average
Fixed
Cost
(AFC)
Units Produced
Average
Variable
Cost
(AVC)
Firm 1:
+
=
Units Produced
Average
Total
Cost
(ATC)
AFC AVC
ATC
Price
Profit
Units Produced
Average
Fixed
Cost
(AFC)
Units Produced
Average
Variable
Cost
(AVC)
Firm 2:
+
=
Units Produced
Average
Total
Cost
(ATC)
AFC
AVC
ATC
Price
Profit
+
+
.
.
.
=
Price
is the
same
Industry Suppl y Curve:
ATC2
ATC1
Q1
Q2
Average
Total
Cost
(ATC) &
Price
Price
And so forth, to include
all firms in industry
Units Produced
ATC
1
ATC2
Firm 1
Firm
2
Q2
Q
1

ENGINEERING MANAGEMENT 302 - 21 -

























Figure 1.9 setting the price of alumina. (Newer refineries enjoy economies of scale and
improved technology thus pushing costs lower).


BREAKEVEN ANALYSIS

Breakeven: the income is equal to expenditure, neither profit nor loss.

Breakeven analysis helps to make decisions on overtimes, expansions, new methods,
modifications, outsourcing, and distribution and marketing of their product. It can affect new
and on-going projects.

Breakeven Analysis can be done by a number of methods:
1. Equation methods
2. Contribution margin methods
3. Graphical methods
Price range
Al umina Industry Cost Curve (1997)*
* Costs based on pre expansions in the mid to late 1990s, which have consequently improved cost positions
** Although Worsley OPEX is lower than Alcoas facilities, their CAPEX was significantly higher ($A1,100/t vs $A500/t fromindustry interviews)
Source: Australian alumina producer, MacQuarie Equities
Opex (US$
per tonne)
Annual producti on (000t)
Worsley** Pinjarra Wagerup Kwinana
Newer and larger refineries
are at the lower end of the
industry cost curve
Uneconomical
All WA Refineries
Profit
Refinery
size
0
50
100
150
200
250
300
0 10,000 20,000 30,000 40,000 50,000

ENGINEERING MANAGEMENT 302 - 22 -





At Breakeven point, if the number of units sold is Q
BE
, then






In breakeven analysis, Fixed and Variable Costs are used to determine the volume of goods to
be produced and to predict the expected profits for a given quantity sold, as in Figure 1.10.














Figure 1.10 Cost and revenue behavior

Example// A mechanical repair shop pays $2,000 for rental (Fixed Cost), conducts repairs
costing $120 (Variable Cost), and charges $200 per unit. Calculate the breakeven point. (Ans:
25). To make a profit of $1,200 how many units need to be repaired? (Ans: 40)

Solution/ Calculate breakeven points if the landlord gives the following options:
$2,000 fixed rent, or
$1,400 rent + 5% of revenue (Ans: 20), or
Nil fixed rent + 20% of revenue.

http://www.youtube.com/watch?v=2cbbWOnH42Y

PRODUCT MIX

Organisations produce many different products. This complicates the break-even and
sensitivity analysis since contribution of different products to the profit becomes different.
Managers often attempt to increase those products that contribute highest profit.

EFFECT of INCOME TAX

Income tax reduces the net profit, but does not affect breakeven point (30% in Australia).

COSTING SYSTEMS IN MANUFACTURING SECTOR

Costing systems varies from one sector to another as well as from industry to industry.

Fixed Costs
Variable
Costs
Profit
R
e
v
e
n
u
e
T
o
ta
l C
o
s
t
$
Quantity
Sold
$ Breakdown at
given Quantity Sol
Break-Even
Point
Breakeven
Volume
Breakeven Volume = Q
BE
= Total Fixed Cost / (Price per unit - Ave Variable Cost per unit)
Price Q
BE
= TFC + AVC Q
BE

Total Revenue =Total Cost
TR = TFC + TVC
ENGINEERING MANAGEMENT 302 - 23 -

Manufacturing is the conversion of raw materials into finished goods. Cost of manufacturing
can be traced as: manufacturing costs and non-manufacturing costs.

Manufacturing costs are:
1. Direct material cost
2. Direct labour cost such as assembly-line workers, machine operators, welders
3. Manufacturing overhead cost such as indirect labour and material, maintenance.

Non- manufacturing cost are:
1. Overhead heat, light, property taxes, depreciation, and administrative costs
2. Marketing advertising, shipping, sales, clerical, management cost
3. Administrative functions executive compensation, general accounting, public relation

Manufacturing/ j ob costing system is used for unique or separately identifiable jobs. Cost
for each item is allocated with minimum averaging.

Example// Job costing of purchase and installation rural area telephone network











Manufacturing / process Costing System is used for many similar mass-produced items.
During the manufacturing process:
1. Units may be fully completed, or
2. Some units are still in the process and are incomplete

http://www.youtube.com/watch?v=sP_CR8zR8f8

COSTING SYSTEMS IN SERVICE & MERCHANDISING

Companies use two basic types of costing systems:

1. J ob costing system: costs are assigned to individual jobs
2. Process costing system: costs are assigned to whole process

ACTIVITY BASED COSTING

Activity based costing (ABC) focuses on activities as the cost objects. There are two types
Products and services: products are ranked for profitability
Customers are classified and ranked for profitability

Example 1/
a) Basic raw materials used in production (VARIABLE COST)
b) Property taxes on administrative buildings (FIXED COST)
c) Emergency maintenance on machinery and equipment (VARIABLE COST)
d) Repair (VARIABLE COST) and maintenance of delivery trucks (FIXED COST)
e) Sales commission (VARIABLE COST)
f) TV advertisement of a product (VARIABLE COST)
Direct cost:
Direct materials 24,000
Direct labour 32,025 56,025

Indirect cost:
Overhead 20,170
Total job cost $76,195
ENGINEERING MANAGEMENT 302 - 24 -

g) Electricity for machinery and equipment in the plant (VARIABLE COST)
h) Property taxes on factory building (FIXED COST)
i) Salaries of design engineers (FIXED COST)
j) Wages paid to temporary workers (VARIABLE COST)
k) Heat and air-conditioning in the plant (FIXED COST)
l) Annual maintenance on machinery and equipment (FIXED COST)
m) Factory fire insurance (FIXED COST)

Example 2/
The Evergreen Associates employs 150 professionals each working 2,000 h pa, 1,250 hours is
chargeable for clients. What is the charging rate in 2011 and 2012? (Ans: $125)


Example 3/
Costs of electronic items are given below. Calculate direct, conversion and total cost per unit.
(Ans: $165, $85, $250)












EVERGREEN ASSOCIATES Profit and Loss Statement (000)
2011 2012

Revenue $21,544 $23,437

Operating costs:
Professional labour 11,250 12,000

Other employee costs
Professional indemnity insurance 561 600
Clerical staff 840 800
Information systems staff 240 300
Administrative staff 300 320
Others 292 2,233 322 2,342

Non- labour operating costs:
Computing hardware and software 460 448
Rent/leasing 1,400 1,500
Phone/fax/ photocopying 1,330 1,122
Travel 718 1,052
Other 275 4,183 286 4,408

Total operating costs 17,666 18,750

Profit $3,878 $4,687
Direct material (5,000 units) 825,000
Conversion costs (5,000 units) 425,000

Total cost to account for (5,000 units) 1,250,000

Direct material cost per unit ?
Conversion cost per unit ?

Manufacturing cost per unit ?
ENGINEERING MANAGEMENT 302 - 25 -


Example 4/
Costs of electronic items are: Direct material $825,000 and conversion cost is $475,000 for
5,000 items. 4,500 items have been completed but the remaining items are half way through
the conversion process. Calculate to cost per unit.































Direct material cost 825,000
Cost per unit (5,000 units) $165

Conversion cost 475,000
Cost per unit (5,000 units) $85

Assignment of costs:
Completed and transferred out (4,500 units) $1,125,000

Work in progress:
Direct material cost (500 units) $ 82,500
Conversion cost (250 units) $ 21,250

Total work in progress $103,750

Total cost accounted for $1,228,750