Module 2: Cost Concepts and Design

Economics
 Chapter Objectives

At the end of this chapter, you will be able to:

• Discuss the fundamental of cost concepts & terminology

• Apply cost concept in design decision

• Analyze short-term alternatives when the time value of

money is not a factor

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 Case Study – UTP

• Established in 1996 (23 yrs ago) as a private higher

education offering engineering and technology
programs.

• The campus was built on a 400 hectares land

formerly the site of USM Engineering Campus at an
estimated costs of RM250 million.

• The academic complex was planned and built at an

estimated costs of RM 1.5 billion.

• The annual operating expenditure (a larger chunk of

it is for emolument) is estimated at RM 300 million.

• The company revenue (from tuition fee collected) is

estimated at RM 150 million and the shortfall is
subsidized by PETRONAS corporate donation to
YUTP.
 Costs

Costs can be categorized in several different ways.

 Fixed cost: unaffected by changes in activity level
 Variable cost: vary in total with the quantity of
output (or similar measure of activity)
 Incremental cost: additional cost resulting from
increasing output of a system by one (or more) units

 Direct: can be measured and allocated to a specific work activity

 Indirect: difficult to attribute or allocate to a specific output or
work activity (also overhead or burden)
 Standard cost: cost per unit of output, established in advance of
production or service delivery
 Example 1 – Costs

Road resurfacing project: asphalt mixing sites

Project require 50,000 cubic yards

Site B has higher capital expenditure but has lower overall costs. Cost
recovered after 24,200 cubic yards delivered
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 Costs Terminologies

Common terminologies for costs

 Cash cost: a cost that involves a payment of cash.
 Book cost: a cost that does not involve a cash
transaction but is reflected in the accounting system.
 Sunk cost: a cost that has occurred in the past and has
no relevance to estimates of future costs and revenues
related to an alternative course of action

 Opportunity cost: the monetary advantage foregone due to limited

resources. The cost of the best rejected opportunity.
 Life-cycle cost: the summation of all costs related to a product,
structure, system, or service during its life span.
 Lifecycle Costs
Total costs of product, structure, systems and services for the entire life of
project

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 Life Cycle Cost Analysis
 When comparing different design alternatives, we need to consider both non-
recurring as well as recurring costs over the life span of each design
alternative.
 Select alternative that fulfill the same performance requirements, but differ
with respect to initial and operating costs
 Example 2 – Pumping System

Pumping System with a Problem Valve

 Decision Problem: Fixing a pumping

system with a faulty valve.
 Design options:
o Option A: Buy a new control valve.

o Option B: Trim the pump impeller

to reduce the pressure.
o Option C: Install a variable-
frequency drive (VFD).
o Option D: Repair the valve as
needed.

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 Example 2 – Pumping System
Cost comparison for all design options

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 Example 2 – Pumping System
Life Cycle Cost comparison for all design options

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 Principle of Economy

Price – Demand Curve

The demand for a product or service is directly related to its price

p = a – bD

P – price D – demand S - supply

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 Minimum Cost Analysis
 Total cost is given in terms of a specific design parameter.
 Find the optimal design parameter that will minimize the total cost.

c
AE(i)  a  bx 
x Total Cost

Capital Cost
Cost ($)

O&M Cost

Design Parameter (x) c

x 
*

b
Optimal Value (x*)
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 Maximizing Total Revenue

Total revenue depends on price and demand.

Total revenue is the product of the selling price per unit, p, and the number
of units sold, D (eq. 2-4).

Calculus can help determine the

demand that maximizes revenue.

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 Maximizing Profit

Profitable venture require higher revenue and lower costs

Profit is revenue minus cost, so

for

Differentiating
 Example 3 – Costs-Volume Analysis

 Profit Maximization for a Short-Run Period

 Profit function
 Total revenue (TR) and total cost (TC) Functions

 Profit Function

 Optimum activity level

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 Exercise 1 – Demand Estimation

Acme Manufacturing is a major player in the lawn sprinkler business.

Their high-end sprinkler is used commercially, and is quite popular with
golf course greens keepers.

In producing these sprinklers Acme’s fixed cost (CF) is $55,000 per

month with a variable cost (cv) of $15.50 per unit.
The selling price for these high-end sprinklers is described by the
equation p=$87.50 – 0.02(D).

a)What is the optimal volume of sprinklers?

Does Acme make a profit at that volume?
b)What is the range of profitable demand?
 Exercise 1 – Profit Estimation

a) What is the optimal volume of sprinklers? Does Acme make a profit

at that volume?

b) What is the range of profitable demand?

Breakeven is found when total revenue = total cost. Solving, we find

the demand at which this occurs (eq. 2-12).
 Design Optimization

Engineers must consider cost in the design of products,

processes and services.
 “Cost-driven design optimization” is critical in today’s competitive
business environment.
 In our brief examination we examine discrete and continuous problems
that consider a single primary cost driver.

Two main tasks are involved in cost-driven design optimization.

1. Determine the optimal value for a certain alternative’s design variable.
2. Select the best alternative, each with its own unique value for the design
variable.
Cost models are developed around the design variable, X.
 Design Optimization

Optimizing a design with respect to cost is a four-step process.

 Identify the design variable that is the primary cost driver.

 Express the cost model in terms of the design variable.
 For continuous cost functions, differentiate to find the optimal value.
For discrete functions, calculate cost over a range of values of the
design variable.
 Solve the equation in step 3 for a continuous function. For discrete, the
optimum value has the minimum cost value found in step 3.
 Cost Function

Here is a simplified cost function.

where,
a is a parameter that represents the directly varying cost(s),
b is a parameter that represents the indirectly varying cost(s),
k is a parameter that represents the fixed cost(s), and
X represents the design variable in question.
 Time Value of Money

“Present economy studies” can ignore the time value of money.

 Alternatives are being compared over one year or less.

 When revenues and other economic benefits vary among alternatives,
choose the alternative that maximizes overall profitability of defect-free
output.
 When revenues and other economic benefits are not present or are
constant among alternatives, choose the alternative that minimizes total
cost per defect-free unit.
Exercise 2 – Economic Considerations

As energy costs continue to rise, power efficiency is increasingly

important. Acme Chemical is evaluating two different electric motors to
drive a mixing motor and needs to perform a present economy study.
The motor will produce 75 hp and will be operated eight hours per day,
365 days for one year (maintenance will be performed on second shift—
assume no down time during operation), after which time the motor will
have no value. Select the most economical motor. Assume Acme’s
electric power costs $0.16 per kWh. 1 hp = 0.746 kW.

Motor A Motor B
Purchase price $3,200 $5,900
Annual maintenance cost $250 $450
Efficiency 75% 85%
Exercise 2 – Economic Considerations

Motor A

Motor B

Higher efficiency motor reduces running costs even though it may

means higher capital costs
 Example 3 – Copper Size

A constant electric current of 5,000 amps is to be transmitted a distance of

1,000 feet from a power station to a substation. Determine the optimal size of
the copper conductor.
• Copper price: $8.25/lb
• Resistance: 0.8145x10-5Ωin2/ft
• Cost of energy: $0.05/kWh
• Density of copper: 555 lb/ft
• Useful life: 25 years
• Salvage value: $0.75/lb
• Interest rate: 9%
 Example 3 – Copper Size

Operating Costs (Energy Loss)

I = current flow in amperes
I 2R
L T R = resistance in ohms
1000 A T = number of operating hours
A = cross-sectional area
50002 (0.008145)
L (24  365)
1000 A
1,783,755
 kWh
A
1,783,755
Energy loss cost  kWh($0.05)
A
$89,188
=
A
 Example 3 – Copper Size

Material Costs
• Material weight in pounds

1000(12)(555)A
3
 3,854 A
12
• Material cost (required investment)
Total material cost = 3,854A($8.25)
= 31,797A
• Salvage value after 25 years: ($0.75)(31,797A)
 Example 3 – Copper Size

Capital Recovery Costs (Value of Money – Chapter 4)

Given:
2,890.6 A
Initial cost = $31,797A
0
Salvage value = $2,890.6A
Project life = 25 years 25
Interest rate = 9%
31,797 A
Find: CR(9%)

CR(9%) = (31,797 A - 2,890.6 A) (A/P , 9%, 25)

+ 2,890.6 A (0.09)
= 3,203 A
 Example 3 – Copper Size

Total Equivalent Economic Cost (Evaluating Project – Chapter 5)

 Total equivalent annual cost
AEC = Capital cost + Operating cost
= Material cost + Energy loss
 Find the minimum annual equivalent
cost

89,188
AEC(9%)  3, 203 A 
A
dAEC(9%) 89,188
 3, 203 
dA A2
0
89,188
A* 
3, 203
 5.276 in 2
 Summary
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 The term costs refers to all types of expenses including

capital, material, operational and maintenance.

 Costs can be either (1) fixed or variable, and (2) codirect or

indirect.

 Cost estimation is a major hurdle in economic analysis as

costs vary in time and uncertainty.