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COST CONCEPTS AND DESIGN EcONOMICS

fl OBJECTIVE:
The objective (~fChapter 2 is to ana(yze short-term altemotives when the time
value olmoney is not alactor. IFe accomplish this "with three types ofproblems:
(1.) Economic breakevell analysis;
(2.) Cost-driven design
n
, . (3.) Present economy studies
II
\.- The word cost (or expense) has meanings that vary in usage. Cost concepts
and other economic principles used in an engineering economy study depend on
'1
I, ', the situation and on the decision to be made. Many types of cost arise in economy
\J studies of a new existing enterprise whenever any change in operations or policy is
made. While an engineer may be cognizant of the various types of cost, it appears
that classifying the same and giving the applications of each will make them
clearer.

MANUFACTURING COSTS
The several types of manufacturing costs incurred by a typical manufacturer
are illustrated in Figure 2.1. In converting raw materials into finished goods, a
manufacturer incurs various costs of operating a factory. Most manufacturing
companies divide manUfacturing costs into three broad categories: direct materials,
u
,
direct labor, and manufacturing overhead.
!" H'"."'.~"_"_.,

I .con.~ai"s f 1
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II Contains
j' .: in-;ve_~~,9_ry 0: _ I , i~ventory of
............. - - -.. - - - -..- .-.-d--

l.!t~. w.!mi., ..,eti~lf.,) . ,:" 'lNPrk ir{ .", ,

Y_!lr~~~~';'"
"".",", -".' -,,:,- ....,;...;;.._....4

,
u Purchase of Manuf~cturing
raw materials costs

Raw materials
~
, _u--- u~
,.
: ~:aw materials :
purchased
: used :
(', : Direct labor :
U ~
,
1
Manufacturing
overhead
:
,I
. _----------"
Cost of goods r------- ---
~ 1 Contains
. .~?.-:::..:t:-':'~ sold ~,
(", ,.: J:6n~~mer "._:")
"~">,:;~~,,,,,""",, . . . /
':(;::====-: Inventory of.
, :',':,~ni~~.-e~,::

I,'u i';,:,(~~?~S,
Figure 2.1 Various types of manufacturing costs

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-~---- --- ----------- - ---~------~'-

 11 I Chapter 2 . Cost Concepts and Design Economics

DIRECT MATERIALS
Direct raw materials refer to any materials that are used in the final
I I product and that can be easily traced into it. Some examples are wood in furniture,
steel in bridge construction, paper in printing firms, and fabric for clothing
manufacturers. It is also important to note that the finished' product of one
company can become the raw materials of another company. For example, the
computer chips produced by Intel are raw'materials used by Dell C'.-omputer in its
personal computers.

DIRECT LABOR
Like the term direct material, direct labor is for those labor costs that go
I I
into the production of a product. The labor costs of assembly-line workers, for
(i example, would be direct labor costs, as would the labor costs of welders in metal
fabricating industries, carpenters or bricklayers in home building, and machine
fl operators in various manufacturing operations.
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MANUl"~~U1UNGOVERHEAD
Manufacturing overhead include all costs of manufacturing except direct
materials and direct labor. In partiCUlar, they include such items as indirect
materials, indirect labor, maintenance and repairs on production equipment, heat
and light, property taxes, depreciation, insurance of manufacturing facilities, and
overtime premium. The most important thing to note about manUfacturing
overhead is the fact that unlike direct materials and direct labor, it is not easily
traceable to specific units of output. In addition, many manufacturing overhead
.~
costs do not change as output changes, as long as the production stays within the
\ I capacity.
U
NON-MANUFACTURING COSTS
There are two additional costs in supporting any manufacturing operations.
They are (II marketing or selling costs and (21 administ:rative costs. Marketing
or selling costs include all costs necessary to secure customer orders and get the
I' I. finished product or service into the hands of the customer.
d Overhead: Heat and light, property taxes, depreciation or similar terms,
associated with its selling and administrative functions.
Marketing: Advertising, shipping, sales travel, sales commissions, and sales
salaries. Administrative costs include all executive, organizational, and
clerical costs associated with the general management of an organization.
Administrative functions: Executive compensation, general accounting,
public relations, and secretarial support.

STANDARD CO.STS
Standard costs are planned costs per unit of output that are established in
advance of actual production or service delivery. They are developed from
anticipated direct labor hours, materials, and overhead categories (with their
established cost per unit). Standard costs play an important role in cost control
and other management functions. Some typical uses are the following:
Estimating future manufacturing costs
Measuring operating performance by comparing actual cost per unit with the
standard unit cost
Preparing bids on products or services requested by customers
Establishing the value of work in process and fmished inventories
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r') 1~ I Chapter 2 . Cost Concepts and Design Economics

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COST CLASSIFICATION FOR PREDICTING COST BEHAVIOR

In engineering economic analysis, we need to predict how a certain cost will
behave in response to a change in activity. For example, a manager will want to
estimate the impact a 5% increase in production will have on the company's total
n wages, before a decision to alter production is made.
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Cost behavior describes how a cost item will react or respond to changes in
the level of business activity. '

FIXED COSTS
Fixe,d costs are those unaffected by changes in activity level over a feasible
n range of operations for the capacity or capability available. Typical fixed costs
I i include insurance and taxes on facilities, general management and administrative
I ,
~. J salaries, license fees, and interest costs on borrowed capital.

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VARIABLE COSTS
Vadable costs are those associated with an operation that varies in total
with the quantity of output or other measures of activity level. Examples of these
costs are the costs of materials and labor used in a product or service.

INCREMENTAL COSTS
An incremental cost (or incremental revenue) is the additional cost (or
I
revenue) that results from increasing the output of a system by on,e (or more) units.
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' This cost is often associated with "go-no go decisions that involve a limited change
in output or activity level.

COST CONCEPTS RELEVANT TO DECISION MAKING

Costs are important feature of many business decisions. In making
(1 decisions, it is essential to have a firm grasp of the concepts of differential cost,
,
, \ opportunity cost, and sunk cost.
l.~

OPPORTUNITY COST
Opportunity cost may be defined as the potential benefit that is given up as
you seek an alternative course of action. It is, incurred because of the use of limited
resources, such as the opportunity to use those resources to monetary advantage
in an alternative use is foregone. Thus, it is the cost of the best rejected (foregone)
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opportunity and is often hidden or implied.
In economic sense, opportunity cost could mean the contribution to income
that is foregone by not using a limited resource in its best use. Or, we may view
opportunity costs as cash flows that could be generated. from an asset the frrm
already owns, provided they are not used for the alternative in question. In general,
accountants do not post opportunity cost in the accounting records of an
organization. However, this opportunity cost must be e,,-,plicitly considered in every
decision.

SUNK COST
Sunk cost is one that has occurred in the past and has no relevance to
estimates of future costs and revenues related to an alternative course of action.
We need to be able to recognize sunk costs and then handle them properly in an
analysis. Specifically, we need to be alert for the possible existence of sunk costs in
any situation that involves a past expenditure that cannot be recovered, or capital
that has already been invested and cannot be retrieved.

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141 Chapter 2 -Cost Concepts and Design Ecanomics
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Utility is the power to satisfY human wants and needs. It is most
commonly measured in terms of value, expressed in some medium of exchange
c') as the price that must be paid to obtain the particular item.
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Goods and services may be divided into two types: necessities and luxuries.
Obviously, these terms are relative, because, for most goods and services, what one
person considers a necessity may be considered a luxury by another. For all goods
and services, there is a relationship between the price that must be paid and the
,~
quantity that will be demanded or purchased.
, : "

p
,.1

p=a-bD

\)
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D
Units of Demand
n
I I Figu... 2.2 - General Price-Demand Relationship
IJ
From Figure 2.2, as the selling price per unit (P) is increased, there will be
r" less dewand (D) for the product, and as the selling price is decreased, the demand
': will increase. The relationship between price and demand can be ..., -pressed as the
U
linear function

for 0:5. D :5. a, and a > 0, b > 0, (2-1)

r b

where a is the intercept on the price axis and -b is the slope. Thus, b is the
amount by which demand increases for each unit decrease in p. Both a and b

u are constants. It follows, of course, that

D=--
a-p
b
(2-2)

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15 I Chaptel' 2 . Cost Concepts and Design Economics

II BREAK-EVEN ANALYSIS
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Break-even analysis involves investments of capital wherein at a
\
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certain level of production, the total income of the company would just be equal
I I, to the total expenses, thus resulting in no loss nor profit-

TOTAL REVENUE FUNCTION

The total revenue, TR, that will result from a business venture during a
given period is the product of the selling price per unit p and the number of units
sold D. Thus,

TR = price x demand = pD (2-3)

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i... J if the relationship between price and demand as given in Eq. 2-1 is used,

TR = {a-bD)D =a-bD2 for O:5D:5~, aM a>O, b>O, (2-4)

The relationship betweerl total revenue and demand for the condition
expressed in Eq. 2-4 m8J7 be represented by the curve shown in Figure 2.3. From
calculus, the demand 15 that will produce maximum total revenue can be obtained
by solving

d1R
--=a-2bD=O (2-5)
dD

a2 a2 a2
MaximumTR = a15 -b15 2 = - - - = -
2b 4b 4b
-----_._--_._--~-~~,
,,
,,
,
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, Price = a - bD
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,,,
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15=-
, 2b

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U Demand
, 1 Figur" 2.3 - Total R"v"nu" Function"" a Function of n"mand
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I ' 17 I Chapter 2 . Cost Concepts and Design Economics
!

Obviously, the conditions for which breakeven and maximum profit occur
are our primary interest, First, at any volume (demand), D,

Profit (Loss) = Total Revenue -Total Costs

n = (aD - bD4) - (Cp + cvD)
I I!
I = -bD 4 + (a - cv)D - CF for 0 :s; D :s; ~ and il > b, b > O. (2-9)

rl
, , In order for a profit to occur, based on equation 2-9, and to achieve the
i ': typical results depicted in Figure 2.4, two conditions must be met:

> 0; that is, the price per unit that will result in no demand has to be
1. (a - cv)
greater than the variable cost per unit. (This avoids negative demand.)
2. Total revenue must exceed total cost for the periods involved.

If these conditions are met, we can find the optimal demand at which maximum
profit will occur by taking the first derivative of equation 2-9 with respect to D and
setting it equal to zero:
II
d(profit)
IJ dD
a- Cv - 2bD = O.

The optimal volume D that maximizes profit is

a-Co (2-10)
D""=--
2b

To ensure that we have maximized profit (rather than minimized it), the sign of the
second derivative must be negative. Checking this, we find that

u d 4 (profit)
dD2 = -2b,
which will be negative for b > O.
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LJ An economic breakeven point for an operation occurs when total revenue
equals total cost. Then for total revenue and total cost, as used in the development
of equation 2-9 and 2-10 and at any demand D,

Total revenue = Total cost (breakeven point)

aD - bD2 = CF + cvD
-bD 2 + (a - cv)D - CF'= O. (2-11)

Because equation 2-11 is a quadratic equation with one unknown (D), we can solve
for the breakeven points D{alld D; (the roots of the equation]:

D' = -(a - cv) ;I (a - cv)2 - 4(-b) (-CF )

2(-b) (2-12)

With the conditions for a profit satisfied, the quantity in the brackets of the
i ) numerator (the discriminant) in equation 2-12 will be greater than zero. This will
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1.J ensure that Di and D; have real positive, unequal values.

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Example 2.1
A company prDduces an electrollic timing switch that is used in consumer and
commercial products. The fixed cost is Php730,OOO per month, and the variable cost is
Php830 per unit. TI,e selling price per unit isp=1800 - O.2D. For this situation,
I, a. Determine the optimal volume for this product and confinn that a profit occurs
Ii (illStead of a loss) at this demand.
\ J b. Find the volume at which breake1Jen occurs; that is, what is the range of
profitable demand?
rl
, ! .16 SOLUTION:
a. Profit = Total Revenue - Total Cost
= pD - (CF + cuD)
= (1800 - 0.2D)D - (730,000 + 830D)
~ 1800D - 0.2D 2 - 730,000 - 830D
Profit ~ -0.2D 2 + 970D - 730,GOO

Takulg the first delivative of the equation and equating it to zero:

d(Profit)
dD
= -0.4D + 970 = 0
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-0.4D =-970
,l~I D= -970
-004
= 2,425 units
To confirm that a profit occurs, instead of a loss~ we take the second de~ivative
of the profit equation:
d'<;;'~fit) -0.4, SUlce the second derivative is negative (-), then the profit is
maximized at 2,425 units.
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b. D' = -970J(970)2-4(-O.2)( 730,000)
-2(0.2)
D; =931.47 and D, = 3,918.53
Thus, the range of profitable demand is 931.47 to 3,918.53 units per month.

n Scenario 2: Price is Independent of Demand

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When the price per unit p for a product or service can be represented more
simply as being independent of demand [versus being a linear function of demand,
as assumed in Equation 2-1] and is greater than the variable cost per unit c., a
single breakeven point results. Then, under the assumption that demand is
immediately met, total revenue (TR) = pD. If the linear relationship for costs in
Equations 2-7 and 2-8 is also used in the model, the typical situation is depicted in
Figure 2.5.

( ,I Based on the definition of break-even and on the given assumptions, we have

I ' the following equation:
l.~
Total Revenue = Total Costs
pD=CF +c"D
Combining similar terms will result in the following simplified equation:
D(p-c,.)=Cp
Letting D' be the point where break-even occurs, we will denote it as D', and thus,
D'= C~
P-c..
('
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191 Chapter 2 .. CDst CDncepts and Design ECDnomics
TR
T
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Pl/
Breakeven Point

D'
Demand

Figure 2.5 - Typical Breakeven chart with Price a eoll$tallt (Scenario 2)

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Example 2.2
A finn has the capacity to promlCe 1 million units of a product per year. At
,, I present, it is able to produce and sell only 600, 000 units yearly at a total revenue of
Php720,000. Annual fixed costs are Php250, 000 and the Ilariable cost per unit is
PhpO.70.

c a. Calculate the firm's annual profit or loss for this production.

b. How many wtits should be sold annually to break-even?
c. lJ the firm can increase its sales to 80% Dffull capacity, what will its profit or
loss be, assuming that its selling price and variable <:ost per unit remain
! I, constant?
~
d. Draw a break-even chart indicating the above results on the chart.

15 SoLUTION:
a. At 600,000 units of production (60'Y;' capacity)
Profit = Total revenue - Total costs
n Profit = Php720,000 -IPhp250,000 + {phpO.70junitx 600,000 units)]
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Profit = Php720,000 - Php670,000
'-' Profit ~ Php50,000

il b.
, \
U Total Revenue' I'hp720,000
Computing for p =- - - - - = Php] .20 per unit
Q 600,000 units

, '=
L) I'hp250,OOO' = .."flO.,(l(lO Units
.
(l'hp1.20 -l'hpO.701 perunit

[: c. At 80% capacity (800,000 units per yeal')

Profit = Total revenue - Total costs
Profit = (800,000 x Php1.20junitJ - {php250,000 + (PhpO.70junit x 800,000)]
Profit = Php960"OOO - Php810,000
II '~ Profit = Php150,000
o

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20 I Chapter 2 - Cost Concepts and Design Economics
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I :
d. Break-even chart
~
Pltl'
, 1,~CKl,IlOU

,
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1,OOll,OOO

Ii, Toial
Revenues
SOO.oro

1ll0,(Hlll
Total costs
tJOo,ooo

'!OO,f100
D'
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300,1100

20D,I)OO
Fixed co::rts

"""--+--+--+---I---!--+---+---II---+--~Q
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!.'OO.OOO 1,1I00,i100

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Example 2.3

An engineeri.ng consulting finn 11leasures its output in a standard service hour unit,
which is a function of the pets01l1lel grade levels in the professional staff. The ,'anable
cost is Php620 per standard service hour. The charge-out mte is Php855.60 per lwut.
The maximum output of the fiml is 160,000 hours, and its fixed cost is Php20,240,OOO
per year. Fat this finn,
a. u,hat is the breakevenpoint in standard sennce hours and in percentage of total

o capacity?
b. what is the percentage reduction in the breakeven point (sensitivity) if fixed
costs are reduced by 10%; if variable cost per hour is reduced by 1 0%; and if the
charge-out rate per hour is increased by 10%?
,.r SOLUTION'

a. D ' = -C-t, - ~.: 20,240, O()O =' 8 908 .:J..!..

t ),
". hours
p - c, 855.60- 620
hours (I ~"",
0'
l" capacIlv
..
= -85.908.32
. = .. J.""
- 160.000 hours
Or their BEP is 53.69% of their annual capacity.

b. If fixed costs will be reduced by 10%,

(', 0.90(20.240,000)
D'=---'-= ' . =77.317.49 hours
p-c, 855.60-620
,;)
! !. 0' d . - f)' 85,90832 hours -77.317.49 hours
io re uclIOn 1Il . = = (1.0
.i.
85,908.32 hours
>-
_E_ A 10% reduction. in fixed cost resulted to 10% reduction in BEP.
 211 Chapter Z . Cost Concepts and Design Bconamics

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I I 15 SOLUTION:
Ii
Ifvariable costs per hour \\'ill be reduced by 10%,
:1I . D ' =-Cj- = 20,240,000 - .0
\)0,.
(llO . 75 hours
}i-c, [855.60-0.90(620)] .

,ore dUC tIOn 1Il

0/ . D'. =
85,908.32 hours-68.010.75
.
hours = O~083
.L
85, ')08.32 hours
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;, A 10% reduction in variable cost per hour resulted to 20.83% reduction in
BE?

If charge-out rate per hour will be increased by 10%,

D '=~= 20,240,000 630 1

'" 21.55 lours
p-I.:,. [1.10(855.60)-6201

'l
01
,Q re.ducllon
'. 1Il
. D' = 85,908.32 hours - 63.. 021.55 hours 0.2664
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.
I 85.908.32 hours
;. A 10% increase in charge-out rate per hour resulted to 26.64% reduction
in BE?

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Synthesis:
The breakeven point is more sensitive to a reduction on variable cost per hour
~
than to the same percentage reduction in the IIXed cost. Furthermore, notice that the
I BE? in this """ample is highly $ensitive to the charge-out rate.
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I 221 Chapter 2 - Cost Concepts and Design Economics
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I NAME: SCORE: _
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I II." COURSE/YEAR:

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I EXERCISE 2
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I Analyze and solve the following problems.
I
I 1. A lash adjuster keeps pressure constant on engine valves, thereby
I increasing fuel efficiency in automobile engines. The relationship between
I price p and monthly demand D for lash adjusters made by the Wicks
roo, I
Company IS " gIVen by t hIS equation:
. " . What IS
D = (2000-p) . the d emand w h en
I 0,10
I total revenue is maximized? What important data are needed if ma.,<:imum
I profit is desired?
I
I es SOLUTION;
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2. A large company in the communication and publishing industry has
quantified the relationship between the price of one its products and the
demand for this product as Price = 150 - 0.01 x Demand for annual printing
lj of this particular product. The fJXed costs per year (Le., per printing) is
L Php50,000 and the variable cost per unit is Php40. What is the maximum
profit that can be achieved if the maximum expected demand is 6,000 units
'~l per year? What is the unit price at this point of optimal demand? What is
\i the range of profitable demand per year?
'--'
es SOLUTION:

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\'...--J-: J __
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I 23 I Chapter 2 - Cost Concepts and Design Economics
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n I NAME: SCORE: _
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I _ COURSE/YEAR: DATE:
I II
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I 3. The annual fIXed costs for a plant ate PhplOO,OOO, and the variable costs
I are Php140,000 at 70% utilization of available capacity, with net sales of
I Php280,OOO. What is the breakeven point in units of production if the
I
I selling price per unit is Php40.
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I Ai SOLUTION:
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I 4. A telephone switchboard 100 pair cable can be made up with either
I enameled wire or tinned wire. There will be 400 soldered connections. The
I
I cost of soldering a connection on the enameled wire will be Php1.65 and on
I the tinned wire it will be Php1.15. A 100-pair cable made up with enameled
I wire costs PhpO.55 per lineal foot and those made up to tinned wire costs
I PhpO.75 per lineal foot. Determine the length of cable run in feet so that the
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cost of each installation would be the same. Determine also the length of
cable at which each alternative is more economical.
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I gSoLUTION:
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