Unit Cost

Problems
Dr. B. C. Paul 2003 revisions 2008
Note The subject covered in these slides is considered to be common
knowledge to those familiar with the subject and books or articles covering the
concepts are widespread.
Cash Flow Problems are
5 Types
Invest and Earn
solve with NPV, maybe IRR or tweeked IRR or ERR
All Cost Investment Alternatives
develop cash flows for alternatives
subtract other choices from favorite choice
Evaluate comparison problem using an invest and
earn technique - especially NPV
Run a basket-ball elimination tournament to pick
the best
Five Types of Cash Flow
Problems
Incremental Investment Problem
Write cash flow for basic investment
Write cash flow with the add on being
evaluated
Subtract the basic cash flow from the one with
the add on - get a cash flow for value of the
add on
Do an NPV or IRR/ERR/Tweeked IRR on the
new cash flow
Five Types of Cash Flow
Problems
Competing Investments Problem
Is no one right answer
Have to choose what strategy you are using
to pursue wealth and then choose your
analysis technique
Last Type of Problem is the Unit Cost
Problem
What is a Unit Cost
Problem?
You take all the costs in a cash flow for building
something and divide the value by the number
of units produced.
Can be very useful for analyzing competitiveness
What are your costs for doing something versus the
cost for someone else
Done by getting your costs on an annual basis
and dividing by number of annual units
produced
Dividing Costs
Ownership Costs
Costs for acquiring and making ready longer lived assets
Operating Costs
Costs for day to day operations
Example Your Car
Cost of Buying the Car payments
Costs of insuring the vehicle
Taxes costs
All occur just to have a ready to run vehicle
Operating Costs
Fuel
Oil
Tires
Repairs
Often Used for Looking
at Items of Equipment
What does it cost to own
What does it cost to operate
May see this break-down in arguments of
when it is time to replace something.
Related but different
Schemes
Capital Costs
Cost to Acquire an asset
Operating Costs
Costs to maintain in a ready to run or running
configuration
Your Car
Capital payments to acquire item
Operating
Insurance / taxes / licensing
Gas / oil / tires / repairs
Used to Analyze Capital
Intensity
Some industries spend most money acquiring
assets
Power Companies or Heavy Industry
Some industries spend most to operate
Retail and Fast Food
Many organizations prefer operating cost
Capital costs not easily liquidated if markets go bad
represent locked in risk
Operating costs often very flexible if you want out
Example Walmart builds very few of their stores
Example Handling Working Capital
An Division of Operating
Fixed and Variable
Fixed costs each year if you want to stay
capable
Variable costs that are a function of deciding
to operate something
Your Car
Fixed payments, taxes, insurance, licensing
Variable gas/ oil / tires / repairs
The Fixed Cost Dilemma
Right Sizing Projects
To small projects generally dont have enough units
to spread fixed costs
Personal Life
High debts fixed money not connected to current
needs
If variable costs (food and gas go up)
The Corporate Problem of Legacy Costs
The Airline Problem fuel efficiency
Getting Ready to Do a
Fixed Cost Problem
We will take all our costs that are on an annual
basis and add them up
We will take all our long term costs that are not
on an annual basis (usually capital goods)
Convert them to annual costs
Once everything is on an annual cost basis we
will divide by # of units produced per year
We will then have our Unit Cost.
Of course objective is to have lowest unit cost
Example

Earnest does mine planning for Crader

Mining
Operating Costs
Each Truck uses $60,000 in diesel fuel
$10,000 in lubricants
$20,000 in repairs
$10,000 in tires
$40,000 for operator
Unit Cost Problem
Total Operating Cost/Year
$60,000+$10,000+$20,000+$10,000+$40,000 =
$140,000 / Year
Annual tonnage produced is 700,000 tons
Operating Cost/Unit is $140,000/700,000 = $0.2/ton
Ownership consists of
Purchase
Taxes and Insurance
Tax Benefits
Purchase Cost
In order to get cost per ton, ownership costs
must be put on an annual basis so it can be
divided by annual production
Earnests trucks cost $700,000 each
Can make it a series of annual payments
Maybe in life it is - Maybe the share holders paid
Break it up as if it were annual payments at
interest rate for loan of shareholders rate
Need the Life of
Equipment or Loan
Mining trucks are often 7 years
Assume shareholders pay and want 15%
rate of return
A/P0.15,7 = 0.2404
$700,000 * 0.2404 = $168,280 / Year
Depreciation

Truck is used up by working it in production

Already said life was 7 years
Simple Way to Depreciate is called
Straight Line
Truck was worth $700,000
Is used up over 7 years
$700,000 / 7 = $100,000 per year used up
Per unit cost analysis uses straight line
More Depreciation
In practice things depreciate faster at first
New car dropping $2000 when drive it off the lot
Other Depreciation Methods such as Sum
of Years Digits
Income tax has schedule IRS developed called
ACRS (Accelerated Cost Recovery Schedule)
Not going to cover right now
Depreciation and Tax
Advantage
Earnests trucks can be depreciated on
Federal and State Income Tax
Government taxes business income just like
yours
Government allows you to deduct from your
income
If self employed you can deduct business expenses
Only pay tax on what you actually cleared
Crader Mining has to buy trucks - its a business
expense taken by depreciation
The Tax Advantage
Straight Line Depreciation give
$100,000/year
Crader will deduct $100,000 from their
reported earnings
Saves them money on taxes - should be
considered in per unit cost
some analysis are done before taxes
some are done after taxes
Large businesses pay was about 36% Federal
and 3% state - now 32% Federal 3% State
Calculating Tax
Advantage
$100,000 deduction
35% tax rate
$100,000 * 0.35 = $35,000
$35,000 in income tax that dont have to pay
Property Tax and
Insurance
Property Tax is about 2%, Insurance is about
2%
Problem is 2% of what?
Insurance and Property Tax are on the value of
the property - which is changing
We need an annual cost but its different every
year
Use what is called Average Annual Investment
 Depreciation and
Average Annual
Investment
$700,000 Initial Value for Tax and Insurance

$600,000 in Note that average value is not middle value

Year 2
of $350,000 which occurs at time 3.5 years
$500,000 in (taxes and insurance are based on value at
Year 3 the beginning of the year)

($700,000 + 600,000 + $500,000 + $400,000 + $300,000+

$200,000 + 100,000)/7 = $400,000

General Formula
$100,000 in (n+1)/2n * Initial Value =
Year 7
Average Annual Investment

0 1 2 3 4 5 6 7
Apply
(7 + 1)/ (2*7) * $700,000 = $400,000 Average Annual Investment

Taxes Are 2% of Average Annual Investment

$400,000 * 0.02 = $8,000
Insurance is 2% of Average Annual Investment
$400,000 * 0.02 = $8,000
Summing Annual
Ownership Cost
$168,400 / year from purchase
$16,000 /year in taxes and insurance
-$35,000 / year in tax savings
$149,400 / year in Ownership Cost
$149,400 / 700,000 tons / year = $0.2134
Finishing the Problem

Ownership Cost/ton = 21.34 cents

Operating Cost/ton = 20.00 cents
Total Cost per ton to move rock with the
haul truck is 41.34 cents/ton
Most Engineering Applications can do a
per unit cost the same way
Often an analysis of choice in trying to justify
or explain new equipment purchases