Lecture 2

2
COST CONCEPTS AND

DESIGN ECONOMICS
Muhammad Aljalali, Ph.D.

Cost Terminology
2
Do its benefits exceeds its costs

Important cost concepts
Economic perspective in engineering design
2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Cost Terminology
3
Fixed, variable, and incremental costs.

Direct, indirect and standard costs.
Cash cost versus book cost.
Sunk cost.
Opportunity cost.
Life-cycle cost.

Cost Terminology
4
Fixed, Variable, and Incremental Costs
Fixed Costs:
Those unaffected by changes in activity level.
Variable Costs:
Those associated with production output.
Incremental Cost:
Additional cost from increasing the output by one unit.

Cost Terminology
5
Fixed, Variable, and Incremental Costs
Cost
Variable Costs
Fixed Costs
Production Volume (Quantity)

Cost Terminology
6
Example 2.1
In connection with surfacing a new highway, a
contractor has a choice of two sites on which to set
up the asphalt mixing plant equipment.
He estimates that it will cost $2.75 per cubic yard
per mile (yd3-mile) to haul the asphalt-paving
material from the mixing plant to the job location.
The table below shows the factors relating to each
site.
Cost Terminology
7
Example 2.1
Site A
Site B

Cost Terminology
8
Example 2.1
Site B Site A
Cost Factor Site A Site B

Average hauling distance 4 miles 3 miles
Monthly rental of site $2,000 $7,000
Cost to set up and remove equipment $15,000 $50,000
Hauling expense $2.75/yd3 -mile $2.75/yd3 -mile
Flagperson Not required $150/day

Cost Terminology
9
Example 2.1
The job required 50,000 cubic yard of mixed asphalt
paving material. It is estimating that 4 months (17 weeks
of five days per week) will be required for the job.
Compare the two sites in terms of their fixed, variable
and total costs. Assume the cost of the return trip is
negligible:
Which is the better site?
For the selected site, how many cubic yards of paving
material does the contractor have to deliver before starting
to make a profit if paid $12 per cubic yard delivered to
the job location?
Cost Terminology
10
Solution 2.1
Site B Site A
Fixed or
Cost Variable Site A Site B
Rent Fixed $8,000 $28,000
Setup Fixed $15,000 $50,000
Flagman Fixed 0 5(17)($150) = $12,750
Hauling Variable 4(50,000)($2.75) = 3(50,000)($2.75) =
$550,000 $412,500
$573,000 $503,250
Site B has the smaller total cost for the job.
Cost Terminology
11
Solution 2.1
The contractor will make profit when:
Total cost = Total Revenue

Fixed costs + Variable costs = Total revenue
$90,750 + 3($2.75)x = $12 x
$90,750 + $8.25 x = $12 x
x = 24,200 yd3
Cost Terminology
12
Solution 2.1
Cost or
revenue TR = p . q
TC = FC + VC
= FC+ cv . q
FC
q Production Volume

Cost Terminology
13
Direct, Indirect, and Standard Cost

Direct costs:
Can measured and allocated to unit cost of production.
Labor and material costs.
Direct costs are variable costs.
Indirect (overhead, burden) costs:

Costs that difficult to allocate to a specific output or work
activity.
There are methods to allocate these costs to production units.
Allocation in proportion to (Direct labor hours, Direct labor costs,
Direct material costs, etc.).
Cost Terminology
14
Direct, Indirect, and Standard Cost

Standard costs:
Representativecost per unit of output.
Developed from:
Direct labor hours, Materials, Overhead categories (certain level of
production).
Some typical uses of standard costs:
Estimating future manufacturing costs.
Measuring operation performance.
Preparing bids.
Establishing the value of work in process and finished inventories.
Cost Terminology
15
Cash Cost versus Book Cost
Cash cost:
The actual cost in transaction.
Book cost:
Accounting or historical cost.
Recovery of past expenditure over a period of time
(depreciation).

Cost Terminology
16
Sunk Cost
The sunk cost is one that occurred in the past

and has no relevance of future costs or
revenues relative to an alternative course of
action.
Replacement of assets example.

Cost Terminology
17
Opportunity Cost
An opportunity cost is incurred because of the

use of limited resources.
The cost of the best rejected (foregone)
opportunity.

Cost Terminology
18
Engineering Life-Cycle Cost

Economy
Studies
Potential for life- Cumulative life-
cycle cost savings cycle cost
Cost
Cumulative
committed life-
cycle cost
Time
0
Needs Conceptual Detailed Production or Operation or Retirement and
assessment; (preliminary) design construction customer use; disposal
definition of design maintenance
requirements and support
ACQUISITION PHASE OPERATION PHASE
Cost Terminology
19
Life-Cycle Cost
Investment cost.
Operating and maintenance cost (O&M).
Disposal cost.

The General Economic Environment
20
Consumer and producer goods and services.

Measure of economic worth.
Necessities, Luxuries, and Price Demand.
Market types.
Cost Volume Relationships.

21
Consumer and Producer Goods and Services

Consumer Goods and Services:
Products or services that are directly used by people to
satisfy their wants.
Examples: (food, clothing, mobiles, TV sets, opera, etc.)
Producer Goods and Services:

Products or services that are used to produce consumer
goods and services.
Examples: (machines, buildings, equipment, buses, etc.)

22
Measures of Economic Worth
Goods and services are produced and

desired because they have utility.
Utility is the power to satisfy human wants
and needs.
Utility is measured in terms of value.
The price is the medium of exchange of value.

23
Necessities, Luxuries, and Price Demand
Necessities.
Luxuries.
Price demand.

24
Price Demand
p
D
Price p=abD
Units of Demand D

25
Competition
Perfect competition.
Monopolistic competition.
Oligopoly.
Monopoly.

26
Total Revenue Function
TR = price demand = p D
TR = (a bD) D = aD bD2
for 0 D a/b and a > 0, b > 0
dTR / dD = a 2bD = 0
= a / 2b

27
Total Revenue Function
Max TR = a b2
Total
Revenue
Demand
28
Cost, Volume, and Breakeven Point Relationships
TR = a D b D2
Cost And CT = CF + CV
Revenue Max.
Profit CV = cv . D
CF
D1 D* D2 Volume (Demand)
29
Profit = TR - CT
Profit = (a D b D2) (cv D + CF)
Profit = b D2 + (a - cv) D CF
d(Profit)/dD = 2b D* + (a - cv) = 0
D* = (a - cv) / 2 b

30

Conditions must exist:
1st: (a cv) > 0
2nd: TR > CT for the period involved
Break Even Points (zero profit):

Profit = b D2 + (a - cv) D CF = 0

, =


31
Example 2.2
A company produce an electronic timing switch.
CF = $73,000 per month,
cv = $83 per unit,
Price = p = $180 0.02 (D)
a) Determine the optimal volume for this product and
confirm that profit occurs,
b) Find the volumes at which breakeven occurs.

32
Solution 2.2 (a)

D* = (a cv)/(2b) = ($180 83)/(2(0.02))
= 2,425 units per month
The Conditions:
1: a cv = $180 83 = $97 > 0 o.k.
2: (TR CT) > 0 for D* = 2,425 units per month
($180(2,425) 0.02(2,425)2) ($73,000 + 83(2,425))
= $44,612 > 0 o.k.

33
Solution 2.2 (b)

Total revenue = Total cost (breakeven point)
- bD2 + (a cv)D CF = 0
- 0.02D2 + ($180 - $83)D - $73,000 = 0
- 0.02 D2 + 97 D 73,000 = 0
.
. ,
, =
.
+ .
= =
.
.
= = ,
.
34
Price is Independent of Demand
TR = p . D Profit
Cost and
Revenue CT = cv . D + CF
Loss
CF
D Volume (Demand)

35
Price is Independent of Demand
= +

36
Example 2.3
An engineering consulting firm measures its output in a
standard service hour unit, which is a function of the
personal grade levels in the professional staff. The
variable cost (cv) is $62 per standard service hour. The
charge-out rate [i.e., selling price (p)] is 1.38cv =
$85.56 per hour. The maximum output of the firm is
160,000 hours per year, and its fixed cost (CF) is
$2,024,000 per year.

37
Example 2.3
For this firm:
a) What is the breakeven point in standard service
hours and in percentage to total capacity?
b) What is the percentage reduction in the breakeven
point (sensitivity) if fixed costs are reduced 10%; if
variable cost per hour is reduced 10%; if both costs
are reduced 10%; and if the selling price per unit is
increased by 10%?

38
Solution 2.3
Cost TR = p . D
Revenue CT = cv . D + CF
CF
D Volume (Demand)

39
Solution 2.3
Cost or TR = p . D
Revenue
CT = cv . D + CF
CF
D Volume (Demand)

40
Solution 2.3 (a)

Breakeven point

=

$, ,
= = ,
$, $
As a percentage
,
= = . = . %
,
41
Solution 2.3 (b)

A 10% reduction in CF gives

=

. ($, , )
= = ,
$, $
As a percentage
, ,
= = %
,
42
Solution 2.3 (b)

A 10% reduction in cv gives

=

$, ,
= = ,
$, (. )$
As a percentage
, ,
= = . %
,
43
Solution 2.3 (b)

A 10% reduction in CF and cv gives

=

. ($, , )
= = ,
$, (. )$
As a percentage
, ,
= = . %
,
44
Solution 2.3 (b)

A 10% increase in p gives

=

$, ,
= = ,
. ($, ) $
As a percentage
, ,
= = . %
,
45
Solution 2.3 (b)

Change in Decrease in
Factor Value(s) Breakeven Point
10% reduction in CF 10.0%
10% reduction in cv 20.8%
10% reduction in CF and in cv 28.7%
10% increase in p 26.6%

Cost-Driven Design Optimization
46
Life cycle of the design (cradle to grave),

Design for the Environment DFE (green
engineering),
Design for energy conservative,
Minimum life cycle costs.
Engineering Design is an economically driven art

47
Minimum LCC is a goal achieved largely in the

early stages of design.
Engineers can accomplish a great deal toward
the goal of minimizing life cycle costs by simply
keeping in mind its importance!
Examples are plentiful in engineering.
The two main tasks:
1) Determine the optimal value for a certain alternatives
design variable,
2) Select the best alternative, each with its unique value for
the design variable.
48
General Type of Cost Models

Fixed cost(s).
Cost(s) that vary directly with the design variable
Cost(s) that vary indirectly with the design Variable

= + +

= + + + +

49
General Approach for optimizing a Design

1. Identify the design variable that is the primary cost
driver.
2. Write an expression for the cost model in terms of the
design variable.
3. Set the first derivative of the cost model with respect to
the continuous design variable equal to zero
4. Solve the equation found in step 3 for the optimum value
of the continuous design variable.
5. For continuous design variables use the second derivative
to determine whether the optimum value is maximum or
minimum.
50
Examples
Examples 2-6 and 2-7 in the textbook.

Present Economy Studies
51
Evaluating past performance Evaluating and predicting future events
Accounting Engineering Economy
Past Future
Present

52
The Rules
RULE 1
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 product or service produced.
RULE 2
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.
53
Examples
Total cost in material selection (example 2-8
in the textbook).
Alternative machine speeds (example 2-9 in
the textbook).
Make versus purchase (outsourcing) studies
(example 2-10 in the textbook).
Trade-offs in energy efficiency studies
(example 2-11 in the textbook).
Homework
54
Self homework:
Problems 2-1, 2-29, 2-36, 2-
43.
Class homework:
Problems 2-4, 2-11, 2-12, 2-
15, 2-20.

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2

COST CONCEPTS AND

Muhammad Aljalali, Ph.D.

Do its benefits exceeds its costs

Economic perspective in engineering design

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Fixed, variable, and incremental costs.

Cash cost versus book cost.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Fixed, Variable, and Incremental Costs

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Fixed, Variable, and Incremental Costs

Production Volume (Quantity)

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Cost Factor Site A Site B

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Total cost = Total Revenue

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Direct, Indirect, and Standard Cost

Indirect (overhead, burden) costs:

Direct, Indirect, and Standard Cost

Cash Cost versus Book Cost

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

The sunk cost is one that occurred in the past

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

An opportunity cost is incurred because of the

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Engineering Life-Cycle Cost

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Consumer and producer goods and services.

Necessities, Luxuries, and Price Demand.

Cost Volume Relationships.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Consumer and Producer Goods and Services

Producer Goods and Services:

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Measures of Economic Worth

Goods and services are produced and

The price is the medium of exchange of value.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Necessities, Luxuries, and Price Demand

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Total Revenue Function

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Total Revenue Function

Cost, Volume, and Breakeven Point Relationships

Cost, Volume, and Breakeven Point Relationships

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Cost, Volume, and Breakeven Point Relationships

Break Even Points (zero profit):

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Solution 2.2 (a)

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Solution 2.2 (b)

Price is Independent of Demand

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

Price is Independent of Demand

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.

2. Cost Concepts and Design Economics Muhammad Aljalali Ph.D.