03-Cost Concepts and Design Economics CHE40A

COST CONCEPTS AND
DESIGN ECONOMICS
CHE40: Engineering Economy
Cost Terminology
General Economic Environment
Cost Concepts and Design Economics

Cost-Driven Design Optimization
Present Economy Studies
Outline
Define and differentiate between types of
cost.
Solve problems involving revenue, profit,
breakeven volume and optimum demand.

Apply the economic analysis procedure in
solving problems in optimization and
present economy studies.
3
Learning Objectives
Cost / Expense
an asset or resource used up in relation to a
revenue-generating activity
unaffected by changes in activity level over
Fixed Costs a feasible range of operations

associated with an operation that vary in
Variable total with the quantity of output
Costs
additional cost that results from increasing

Incremental the output of a system by one unit
Cost
4
Cost Terminology
repetitive and occur when an
organization produces similar
Recurring goods or services on a continuing
Costs basis

nonrepetitive, although the total
expenditure may be cumulative
Nonrecurring over a relatively short period of
Costs time
Cost Terminology
can be reasonably measured
and allocated to a specific
Direct Costs output or work activity

difficult to attribute or
allocate to a specific output
Indirect or work activity
Costs
Cost Terminology
involves payment of cash
Cash Cost and results in a cash flow

does not involve a cash
Book Cost transaction
Cost Terminology
has occurred in the past and has
no relevance to estimates of
future costs and revenues related
Sunk Cost to an alternative course of action

the cost of the best rejected
opportunity and is often hidden
Opportunity or implied
Cost
Cost Terminology
funds required for current assets needed
for the startup and support of operational
Working Capital activities
recurring expenses associated with the

operation phase of the life cycle

Operation and
Maintenance
Costs
nonrecurring expenses of shutting down

the operation and the retirement and
Disposal Cost disposal of assets at the end of the life cycle
Cost Terminology
Consumer Goods and Producer Goods and
Services
directly used by people to satisfy
Consumer their wants

used to produce consumer goods
Producer
10

Measures of Economic Worth
Goods and services are produced and desired
because directly or indirectly they have utility the
power to satisfy human wants and needs. Utility is
most commonly measured in terms of value,

expressed in some medium of exchange as the price
that must be paid to obtain the particular item.
11

The Total Revenue Function
TR pD ( 2-3 )
p a bD ( 2-1 )
Demand to produce maximum total revenue

d TR

^ ^
D; TRmax p D ( 2-5 )
dD
TR p D
^
total
revenue price demand
D Demand
maximum
for
TR
12

13
Cost, volume and breakeven point
CT CF CV ( 2-7 )
Variable cost
CV c * D ( 2-8)

CT total cost
CF Fixed cost
CV Variable
c Variable
cost per
D Breakeven
cost demand
unit
14

15
Cost, revenue, breakeven as function of Volume

Profit (loss)
Pr TR CT ( 2-9)
Pr pD CT
The Optimal Demand, D* Pr D* Optimal

d Pr d pD CT
profit demand
0
dD dD
Prmax pD * CT
2
to maximizeprofit
d Pr
2 16
dD
The Breakeven Point
Pr 0; TR CT ( 2-11)
D' __(breakeven demand)

17

18
Pr 0; TR CT
A large wood products company is negotiating a contract to sell
plywood overseas. The fixed cost that can be allocated to the
production of plywood is $ 900,000 per month. The available
cost per thousand board feet is $ 131.50. The price charged will
be determined by 600 0.05D . Determine the optimal monthly

sales volume for this product and calculate the profit (or loss) at
the optimal volume. What is the domain of profitable
demand?
Given:
fixedcost : CF $900,000
variable cost : CV $131.50D
price : p 600 0.05D
19

Required:
Optimal sales volume , D*
Profit (or loss)
Range of profitable demand
Solution:

profit equation : Pr TR CT pD CF CV
Pr 600 0.05DD 900,000 131.5D
Pr 0.05D 2 468.5D 900,000
20
SP1
Optimal sales volume, D*
d Pr d

dD dD

0.05D 2 468.5D 900,000 0
0.1D* 468.5 0
468.5
D* 4,685 units

0.1
Profit (or loss)

Pr 0.054,685 468.54,685 900,000
2
Pr $197,461.25 per month
21
SP1
Range of profitable demand (breakeven)
Pr 0 0.05D'2 468.5D'900,000
D' is from 2,698 to 6,672 units

22
SP1
A soft drink company with bottling plant automation software
installed incurs an annual fixed cost of $10,000. Direct labor is
$3.50 per package and material cost is $4.50 per package. The
selling price will be $12.50 per package. What is the breakeven
point in $ and in units?

Given:
fixedcost : CF $10,000
variable cost : CV $3.50D $4.50D
price : p $12.50
23

Required:
Breakeven point, D, units and $
Solution
profit equation : Pr TR CT pD CF CV
Pr 12.50D 10,000 8D

Pr 4.50D 10,000
at breakeven :
10,000
Pr 0; D'
4.50
D' 2,222 units $27,777.78 at $12.50 selling price
24
SP2
Main tasks of design optimization
determination of the optimal value for a
certain alternatives design variable
selection of the best alternative based on

the value of the design variable
25

Steps
identify the design variable (primary cost
driver)
write an expression for the cost model in
terms of the design variable

set the first derivative of the cost model
with respect to the design variable to zero
solve the equation
use the second derivative of the cost model
to determine whether the optimum value
is a maximum or a minimum
26

A farmer estimates that if he harvests his soybean crop now, he
will obtain 1,000 bushels, which he can sell at $3.00 per bushel.
However, he estimates that this crop will increase by an
additional 1,200 bushels of soybeans for each week he delays
harvesting, but the price will drop at a rate of 50 cents per

bushel per week. In addition, it is likely that he will experience
spoilage of approximately 200 bushels per week for each week
he delays harvesting. When should he harvest his crop to obtain
the largest net cash return, and how much will be received for
his crop at that time?
27

Cost model expression for revenue, R
bushels $3 bushel $2.5 0.5t
R 1000 1,200 200 t
week bushel week bushel
R 3000 10002.5 0.5t t
R 3000 2500t 500t 2
First derivative of cost model

dR
2500 1000t* 0
dt 2500
t* 2.5 weeks
1000
Maximum revenue, R*
R* 3000 25002.5 5002.5
2
R* $ 6,125
28
SP3
The cost of operating a large ship, Co varies as the square of its
velocity, v; specifically,
Co knv 2
Where n is the trip length in miles and k is the constant of

proportionality. It is known that at 12 mi/h the average cost of
operation is $100 per mile. The owner of the ship wants to
minimize the cost of operation, but it must be balanced against
the cost of the perishable cargo, Cc, which the customer has set
at $1,500 per hour. At what velocity should the trip be planned
to minimize the total cost, CT?
29

Given:
cost of operating a large ship : Co kn 2
n : trip length[miles]
Co $100

n mile
mile
12

hr
$1500
Cc
hr
Required:
to minimizeCT ; CT Co Cc
30
SP4
Solution:
solving for k,
Co $100
$ hr 2
k n2 mile 0.694
mile
2
mile 3
12
hr

CT Co Cc
cost model expression,

$1500n
CT 0.694n
2
where t
n
31
SP4
minimizetotal cost,
dCT d $1500n
0.694n
2
d d
dCT
0 1.388n 1500n 2
d

mile
10.26
hr
32
SP4
When revenues and other economic benefits are
present and vary among alternatives, choose the
alternative that maximizes overall profitability
based on the number of defect-free units of a
product or service produced.

When revenues and other economic benefits are not
present or are constant among alternatives,
consider only the costs and select the alternative
that minimizes total cost per defect-free unit of
product or service output.
33

Total Cost in Material Selection
Alternative Machine Speeds
Making vs Purchasing Studies

Trade-Offs in Energy Efficiency Studies
34

In the design of an automobile radiator, an engineer has a
choice of using either a brass-copper alloy or a plastic molding.
Either material provides the same service. However, the brass-
copper alloy weighs 25 pounds, compared with 20 pounds for
the plastic molding. Every pound of extra weight in the

automobile has been assigned a penalty of $6 to account for
increased fuel consumption due to the life cycle of the car. The
brass-copper alloy casting costs $3.35 per pound, whereas the
plastic molding costs $7.40 per pound. Machining costs per
casting are $6.00 for the brass-copper alloy. Which material
should the engineer select? What is the difference in unit costs?
35

Given:
Cost factor Brass-copper alloy Plastic molding
Casting/pc 25lb at ($3.35/lb) 20lb at ($7.40/lb)
Machining/pc $ 6.00 $ 0.00
Weight penalty/pc (25lb-20lb)($6/lb) $ 0.00
Required:

Material to choose; difference in unit cost
36
SP5
Solution:
Cost factor Brass-copper alloy Plastic molding
Casting/pc $25lb($3.35/lb) = $83.75 20lb($7.40/lb)= $148.00
Machining/pc $ 6.00 0.00
Weight penalty/pc (25lb-20lb)($6/lb) = $30.00 0.00
Total cost/pc $ 119.75 $ 148.00

Difference in unit cost = $ 148.00 - $ 119.75
= $ 28.25
Engineer should choose the brass-copper alloy
37
SP5
Two alternative designs are under consideration for a tapered
fastening pin. The fastening pins are sold for $0.70 each. Either
design will serve equally well and will involve the same
materials and manufacturing cost except for the lathe and
drilling operations.

Design A will require 16 hours of lathe time and 4.5 hours of drill
time per 1,000 units. Design B will require 7 hours of lathe tie
and 12 hours of drill time per 1,000 units. The variable cost of
the lathe, including labor, is $18,60 per hour. The variable
operating cost of the drill, including labor, is $16.90 per hour.
Finally, there is a sunk cost of $5,000 for Design A and $9,000
for Design B due to obsolete tooling. Which design should be
adopted if 125,000 units are sold each year?
38

Given:
Cost factor Design A Design B
Lathe time/1000 units 16 h 7h
Drill time/1000 units 4.5 h 12 h
Sunk cost $ 5,000 $ 9,000
Variable cost of the lathe, $18.60/hr

Variable cost of drilling (with labor) $16.90/hr
125,000 units sold each year
Required
Basis for choosing design
39
SP6
Solution:
Cost Design A Design B
factor
Lathe cost (16 h/1000 units) * ($18.60/hr) (7 h/1000 units) * ($18.60/hr)
* 125,000 units = $ 37,200.00 * 125,000 units = $ 16,275
Drill cost (4.5 h/1000 units) * (12 h/1000 units) *
($16.90/hr) * 125,000 units = ($16.90/hr) * 125,000 units =
$ 9,506.25 $ 25,350

Sunk cost $ 5,000 $ 9,000
Total Cost $ 46,706.25 $ 41,625.00
Cost/unit $ 0.37365 $ 0.333
Sunk cost was not included in the

computation because it does not affect
analysis of future costs
SelectDesign B
40
Savings = $ 46,706.25 41,625 = $ 5,081.25
SP6
Compare the total probable part cost from Machine A and
Machine B, assuming that each will make the part to the same
specification. Which machine should be chosen?
A B
Initial capital investment, $ 35,000 150,000

Life, years 10 8
Market (salvage) value, $ 3,500 15,000
Parts required per year 10,000 10,000
Time to make one part, min 20 10
Maintenance cost per year, $/yr 1,000 3,000
Assume that interest is negligible.

41

Given:
A B
Initial capital investment, $ 35,000 150,000
Life, years 10 8
Market (salvage) value, $ 3,500 15,000
Parts required per year 10,000 10,000
Time to make one part, min 20 10

Maintenance cost per year, $/yr 1,000 3,000
Required:
Choice of machine
42
Solution:
Total cost for Machine A:
$ 1,000
CT $ 35,000 10 yr - $3,500 $41,500
yr
Total cost for Machine B:
$ 3,000

CT $ 150,000 8 yr - $ 15,000 $ 159,000
yr
CHOOSE MACHINE A
43
A municipal solid-waste site for a city must be located at Site A
or Site B. After sorting, some of the solid refuse will be
transported to an electric power plant where it will be used as
fuel. Data for the hauling of refuse from each site to the power
plant is as follows:

Site A Site B
Average hauling distance, miles 4 3
Annual rental fee for solid waste, $ 5,000 100,000
Hauling cost, $ per yd3-mile 1.50 1.50
If the power plant will pay $8.00 per cubic yard of sorted solid
waste delivered to the plant, where should the solid waste site
be located? Assume that 200,000 cubic yards of refuse will be
hauled to the plant for one year only. 44

Given:
Site A Site B
Sorted solid waste delivered to plant $8.00/yd3

Refuse hauled to plant per year - 200,000 yd3
Required:
Choice of plant location
45
SP8
Solution:
Site A Site B
For site A
$8 $ 1.50

200,000yd 3 4mi - $5,000

R 3 200,000 yd 3
3
yd yd - mi
R $395,000
For site B
$8 $ 1.50

R 3 200,000 yd 3
3

200,000yd 3 3mi - $100,000
yd yd - mi
R $600,000
46
CHOOSE SITE B
SP8
Either tool steel or carbon steel can be used for the set of tools
on a certain lathe. It is necessary to sharpen the tools
periodically. Relevant information is given below:
Carbon Steel Tool Steel
Output at optimum speed, pcs/h 100 130

Time between tool grinds, h 3 6
Time required to change tools, h 1 1
Cost of unsharpened tools, $ 400 1,200
Number of times tools can be grounded 10 5
The cost of the lathe operator is $14 per hour, including the tool-
changing time during which he is idle. The tool changer costs
$20 per hour just for the time he is changing tools. Variable
overhead costs for the lathe are $28 per hour, including tool-
changing time. Which type of steel should be used? 47

Given:
Carbon Steel Tool Steel
Output at optimum speed, pcs/h 100 130
Time between tool grinds, h 3 6
Time required to change tools, h 1 1
Cost of unsharpened tools, $ 400 1,200
Number of times tools can be grounded 10 5

Cost/hr, lathe operator, $ 14.50 14.50
Cost/hr, tool changer, $ 20 20
Cost/hr, variable overhead for lathe 28 28
Required:
Choice of steel to use
48
SP9
For Carbon Steel:
cycle time 3 1 4 hr
8
cycles per day 2 cycles per day
4
$14 h cycle
lathe operator cost 4 2 $112 per day
hr cycle day
$20 h cycle
tool changer cost 1 2 $40 per day

hr cycle day
$28 h cycle
overhead cost 4 2 $224 per day
hr cycle day
$400 cycle
tool cost 2 $80 per day
10 cycle day
pc hr cycle
daily production 100 3 2 600 pc/day
hr cycle day
49
112 40 224 80
unit cost $0.76 per unit
SP9 600
For Tool Steel:
cycle time 6 1 7 hr
8
cycles per day 1.14 cycles per day
7
$14 h cycles
lathe operator cost 7 1.14 $111.72 per day
hr cycle day
$20 h cycle
tool changer cost 1 1.14 $22.8 per day

hr cycle day
$28 h cycle
overhead cost 7 1.14 $223.44 per day
hr cycle day
$1,200 cycle
tool cost 1.14 $273.6 per day
5 cycle day
pc hr cycle
daily production 130 6 1.14 889 pc/day
hr cycle day
50
111.72 22.8 223.44 273.6
unit cost $0.71 per unit
SP9 889
51
CHOOSE TOOL STEEL
SP9
Suppose we know that
The total cost per year can be approximated by

Determine the value of D that maximizes the profit.
Given:
D
p 1000
5
CT 1000 2D 2
Required:
D* 52
Additional Problems
Solution:
profit equation
Pr TR CT 1000 D 1000 2 D 2
D
5
Pr 2.2D2 1000D 1000
d Pr
4.4 D* 1000 0

dD
1000
D
*
227.27 228 units
4.4
53
SP10
A company has established that the relationship between the
sales price for one of its products and the quantity sold per
month is approximately
The fixed cost is $800 per month and the variable cost is $30 per
unit produced. What would be the maximum profit?

Determine the range of profitable demand.
Given:
p 78 0.10D
CF / month $800 c $30
Required:
Prmax D'min and D'max
54
Additional Problems
Solution:
Profit equation
Pr TR CT pD CT
Pr 78 0.1DD 800 30D
Pr 78D 0.1D2 800 30D
Pr 0.1D2 48D 800

d Pr
0.2 D * 48 0
dD
48
D* 240 units
0.2
Prmax 0.1240 48240 800 $4,960
2
55
SP11
Breakeven
Pr TR CT 0
78 0.1DD 800 30D 0
78D 0.1D2 800 30D 0
0.1D2 48D 800 0

D' 18 units and 463 units
56
SP11
Lumber put through the planer increases in value by $0.10 per
board foot. When the planer is operated at a cutting speed of
5,000 feet per minute, the blades have to be sharpened after 2
hours of operation, and the lumber can be planed at the rate of
1,000 board-feet per hour. When the machine is operated at

6,000 feet per minute, the blades have to be sharpened after
1.5 hours of operation and the rate of planing is 1,200 board-
feet per hour. Each time the blades are changed, the machine
has to be shut down for 15 minutes. The blades, unsharpened,
cost $50 per set and can be sharpened 10 times before having
to de discarded. Sharpening costs $10 per set. The crew that
operates the planer changes and resets the blade. At what
speed should the planer be operated?
57
Additional Problems
For Machine Speed 5,000 feet per minute:
cycle time 2 0.25 2.25 hr
8
2.25
value added by planning
$ bd ft cycles h
0.10 1000 3.56 2 $712 per day
bd - ft h day cycle

$ cycle
sharpening cost 10 3.56 $35.6 per day
cycle day
$ 50 cycle
material cost 3.56 $17.8 per day
10 set day
Revenue 712 35.6 17.8 $659 per day
58
SP12
For Machine Speed 6,000 feet per minute:
cycle time 1.5 0.25 1.75 hr
8
1.75
value added by planning
$ bd ft cycles h
0.10 1200 4.57 1.5 $822.6 per day
bd - ft h day cycle

$ cycle
sharpening cost 10 4.57 $45.7 per day
cycle day
$ 50 cycle
material cost 4.57 $22.9per day
10 set day
Revenue 822.6 45.7 22.9 $754 per day
59
CHOOSE Machine Speed 6,000 feet per minute
SP12
A bicycle component manufacturer produces hubs for bike
wheels. Two processes are possible for manufacturing, and the
parameters of each process are as follows:
Process 1 Process 2
Production rate 35 parts/h 15 parts/h

Daily production time 4 h/d 7 h/d
% of parts rejected 20% 9%
Assume that the daily demand of hubs allows all defect-free
hubs to be sold. Additionally, tested or rejected hubs cannot be
sold. Find the process that maximizes profit per day if each
part is made from $4 worth of material and can be sold for $30.
Both processes are fully automated, and variable overhead cost
is charged at the rate of $40 per hour. 60
Additional Problems
For Process 1:
$ parts h
Total Revenue 30 35 4 0.80 $3,360 per day
part h day
$ part h
material cost 4 35 4 $560 per day
part h d

$ 40 h
overhead cost 4 $160 per day
h day
Net profit 3360 560 160 $2,640 per day
61
SP13
For Process 2:
$ parts h
Total Revenue 30 15 7 0.92 $2,898 per day
part h day
$ part h
material cost 4 15 7 $420 per day
part h d

$ 40 h
overhead cost 7 $280 per day
h day
Net profit 2898 420 280 $2,198 per day
CHOOSE PROCESS 1
62
SP13
Cost Terminology

63
Outline
Sullivan,W., Wicks, E. and Luxhoj, J.,
Engineering Economy, 12th ed, USA:
Pearson Education, Inc., 2003
Blank,L. and Tarquin, A., Engineering

Economy, 4th ed, Singapore: McGraw-Hill
Book Co, 1998
Eschenbach, T., Engineering Economy

Applying Theory to Practice, USA: 1995
64
References
03
COST CONCEPTS AND
DESIGN ECONOMICS
CHE40: Engineering Economy

03-Cost Concepts and Design Economics CHE40A

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COST CONCEPTS AND

General Economic Environment

Cost Concepts and Design Economics

Present Economy Studies

Cost Concepts and Design Economics

Cost Concepts and Design Economics

additional cost that results from increasing

Cost Concepts and Design Economics

Cost Concepts and Design Economics

Cost Concepts and Design Economics

Cost Concepts and Design Economics

recurring expenses associated with the

Cost Concepts and Design Economics

nonrecurring expenses of shutting down

Cost Concepts and Design Economics

General Economic Environment

Cost Concepts and Design Economics

General Economic Environment

Demand to produce maximum total revenue

Cost Concepts and Design Economics

General Economic Environment

Cost Concepts and Design Economics

General Economic Environment

Cost, revenue, breakeven as function of Volume

Cost Concepts and Design Economics

D' __(breakeven demand)

Cost Concepts and Design Economics

General Economic Environment

Cost Concepts and Design Economics

General Economic Environment

Cost Concepts and Design Economics

Cost Concepts and Design Economics

Profit (or loss)

Pr $197,461.25 per month

Cost Concepts and Design Economics

Cost Concepts and Design Economics

General Economic Environment

Cost Concepts and Design Economics

Cost Concepts and Design Economics

Cost-Driven Design Optimization

Cost Concepts and Design Economics

Cost-Driven Design Optimization

Cost Concepts and Design Economics

Cost-Driven Design Optimization

First derivative of cost model

Cost Concepts and Design Economics

Where n is the trip length in miles and k is the constant of

Cost Concepts and Design Economics

Cost-Driven Design Optimization

Cost Concepts and Design Economics

Cost Concepts and Design Economics

cost model expression,

Cost Concepts and Design Economics

Cost Concepts and Design Economics

Present Economy Studies

Cost Concepts and Design Economics

Present Economy Studies

Cost Concepts and Design Economics

Present Economy Studies

Cost Concepts and Design Economics

Cost Concepts and Design Economics

Cost Concepts and Design Economics

Present Economy Studies

Variable cost of the lathe, $18.60/hr