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CHAPTER 2
COST CONCEPTS AND THE ECONOMIC ENVIRONMENT
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COST TERMINOLOGY
There are variety of costs to be considered in an engineering economy analysis.
These costs differ in their frequency of occurrence, relative magnitude, and degree of impact on the study.
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Engineering economic analysis is primarily concerned with comparing alternative projects.
The comparison process utilises a variety of cost terminologies and cost concepts.
Cost terminology: life-cycle costs Sunk costs Opportunity costs Direct, indirect, and standard costs Fixed and variable costs Incremental costs.
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LIFE-CYCLE COST
Life-cycle cost is the summation of all costs, both recurring and nonrecurring, related to a product, structure, system, or service during its life span.
Life cycle costs:
1. First cost (initial investment)
2. Operating and maintenance costs
3. Disposal cost
Acquisition phase:
Need assessment
Conceptual design
Detailed design
Operation phase:
Production
Operation
Retirement
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First cost or Investment cost
Ex: a purchase of machine tool, the first cost may consist of the following elements:
Basic machine cost Cost of training personnel Shipping and installation costs (installation costs: foundation,
vibration and noise insulation, light and power supply, testing and commissioning costs)
Initial tooling costs Supporting equipment costs (computer control ware, spare parts
inventory)
Some projects may include working capital for inventories, cash for wages, materials, etc. Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities;
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Operating and maintenance costs
These are recurring costs that are required to operate and maintain the item during its useful life.
Labour Material Overheads: water and electricity, insurance, inventory, indirect labour,
administrative and management expenses.
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Disposal cost
This situation occurs when the life cycle of an item has ended.
Labour and material costs for removal of the item Shipping cost Special costs (disposing of hazardous materials)
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SUNK COST A sunk cost is one that has occurred in the past and it is
unrecoverable. It has no relevance to decisions because it cannot be changed
regardless of what decision is made now or in the future.
Example:
Let say you have spent RM3 million on a project that requires another RM2 million for completion (you are contemplating to proceed),
You recently determined the project would bring in RM3 million. Do you proceed?
Yes, Absolutely. The first RM3 million is gone (sunk cost), no matter what you do. The next RM2 million investment will, in effect generate a 50% return {(3-2)/2*100%}.
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OPPORTUNITY COST
An opportunity cost is incurred because of the use of limited resources, such that the opportunity to use those resources to monetary advantage in another alternative use is foregone.
Example:
Consider an employee who could earn RM25,000 for working during a year but chooses instead to go to college for a year and spend RM10,000 to do so.The opportunity cost of going to college for that year is RM35,000; (RM10,000 cash outflow and RM25,000 for income foregone)
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DIRECT, INDIRECT COSTS
Direct costs can be reasonably measured and allocated to a specific output or work activity --- labor and material directly allocated to a product, service or construction activity;
Indirect costs are difficult to allocate to a specific output or activity --- costs of common tools, general supplies, and equipment maintenance ;
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OVERHEAD COSTS
Overhead costs consist of all costs of manufacturing other than direct labor and direct material costs --- insurance premium, rent, maintenance and repairs, supervisory and administrative personnel, utilities, depreciation.
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FIXED COSTS Fixed costs are those unaffected by changes in
activity level over a feasible range of operations for the capacity or capability available.
Typical fixed costs include insurance and taxes on facilities, general management and administrative salaries, license fees, and interest costs on borrowed capital.
When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected.
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VARIABLE COSTS
Variable costs are those associated with an operation that vary in total with the quantity of output or other measures of activity level.
Example of variable costs include : costs of material and labor used in a product or service, because they vary in total with the number of output units -- even though costs per unit remain the same.
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Direct, Indirect, and Overhead Costs
A cost structure for manufacturing
Direct material
Direct labour
Indirect material
Indirect labour
Fixed and miscellaneous
General and administrative
Selling
Profit
Conversion costs
Selling price
Prime costs
Factory overhead
costs
Cost of goods manufactured
Cost of goods sold
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Manufacturing Account RM
Work in progress 18,500
Cost of raw materials 1,850,000
Production wages 850,000
PRIME COST 2,700,000
FACTORY OVERHEAD EXPENSES:
Acids and diesel 53,000
Electricity and water 108,900
Repair and maintenance 158,000
Depreciation 150,000
Indirect wages 90,500
Insurance 38,100
Labour safety and attire 17,200
Medical 12,000
Staff training 10,000
637,700
3,337,700
3,356,200
Less: Work-in-progress 12,090
COST OF PRODUCTION 3,344,110
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RECURRING COSTS
Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis.
Variable costs are recurring costs because they repeat with each unit of output .
A fixed cost that is paid on a repeatable basis is also a recurring cost:
– Office space rental
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NONRECURRING COSTS
Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time;
Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself;
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INCREMENTAL COSTS incremental cost is the additional cost that results from
increasing the output of a system by one unit. Incremental cost is often associated with “go / no go”
decisions that involve a limited change in output or activity level.
EXAMPLE the incremental cost of driving an automobile might be
$0.27 / mile. This cost depends on:– mileage driven; – mileage expected to drive; – age of car;
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CONSUMER GOODS AND PRODUCER GOODS AND SERVICES
Consumer goods and services are those that are directly used by people to satisfy their wants;
Producer goods and services are those used in the production of consumer goods and services: machine tools, factory buildings, buses and farm machinery are examples;
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TNB
Consumers:
Households, Industries, Commercial Complexes, Administrative Complexes, Schools, Hospitals, etc.
Suppliers:
Technology, Machines and Equipment, Services, Contractors
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Measures of Economic Worth
Goods and services are produced because they have utility – the power to satisfy our needs.
They may be used or consumed directly, or they may be used to produce other goods or services.
Utility – measured in terms of value
Expressed - price that have to be paid for the goods or services
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Necessities, Luxuries, and Price-Demand
Goods and services may be divided into two categories:
(1) Necessities
(2) Luxuries
For all goods and services, there is a relationship between the price (p) that must be paid and the quantity (D) that will be demanded or purchased.
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Demand Curve
Price (p)
Quantity (D)
D
The law of demand – when price increases, quantity demanded will reduce, vice versa.
From the point of view of consumers
Important assumption:Price is the only factor influencing the buyer’s decision to maximize their satisfaction
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Supply Curve
Quantity (S)Quantity (S)
Price Price ((pp))
SS
The law of supply – when price increases, quantity supplied will increase, vice versa.
From the point of view of suppliers
Important assumption:
Price is the only factor influencing the supplier’s decision to maximize profits
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PRICE
QUANTITY ( D )
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PRICE
QUANTITY ( D )
Price equals some constant value minus some multiple of the quantity demanded:p = a - b D
a
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PRICE
QUANTITY ( D )
Price equals some constant value minus some multiple of the quantity demanded:
p = a - b D
a
a = Y-axis (quantity) intercept, (price at 0 amount demanded);
b = slope of the demand function;
The relationship between price and demand can be expressed as the linear function p = a - b D
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PRICE
QUANTITY ( D )
Price equals some constant value minus some multiple of the quantity demanded:
p = a - b D
a
a = Y-axis (quantity) intercept, (price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
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PRICE
QTY
Price equals some constant value minus some multiple of the quantity demanded:
p = a - b D
a
a = Y-axis (quantity) intercept, (price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
Total Revenue
QTY
TR = p*D = (a-bD)DMR = dTR / dD = a –2bD = 0
MR=0
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PRICE
QTY
Price equals some constant value minus some multiple of the quantity demanded:
p = a - b D
a
a = Y-axis (quantity) intercept, (price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
Total Revenue
QTY
TR = p*D = (a-bD)DMR = dTR / dD = a –2bD = 0
MR=0
TR = Max
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Co
st /
Rev
enu
e
Quantity ( Output )Demand
Marginal ( Incremental) Cost
Co
st /
Rev
enu
e
Quantity ( Output )Demand
Cf
Ct = Cv + Cf
D’1 D’2D*
Profit Total Revenue
MaximumProfit
Profit is maximum when Total Revenue exceeds
Total Cost by greatest amount
D’1 and D’2 are breakeven points
MarginalRevenue
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PROFIT MAXIMIZATIOND*
Occurs where total revenue exceeds total cost by the greatest amount;
Occurs where marginal cost = marginal revenue;
D* = [ a - (Cv) ] / 2b
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BREAKEVEN POINTD’1 and D’2
Occurs where TR = Ct
( aD - bD2 ) = Cf + (cv ) D
- bD2 + (a – cv) D - Cf = 0
Using the quadratic formula:
-( a - cv ) + [ (a - cv) 2 - 4(-b) (-Cf)]1/2
2(-b)
D’ =
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PRESENT ECONOMY STUDIES When alternatives for accomplishing a task are
compared for one year or less (i.e., influence of time on money is irrelevant)
Rules for Selecting Preferred AlternativeRule 1 When revenues and other economic benefits are present and vary among alternatives, choose alternative that maximizes overall profitability based on the number of defect-free units of output
Rule 2 When revenues and economic benefits are not present or are constant among alternatives, consider only costs and select alternative that minimizes total cost per defect-free output
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PRESENT ECONOMY STUDIES
Total Cost in Material Selection
In many cases, selection of among materials cannot be based solely on costs of materials. Frequently, change in materials affect design, processing, and shipping costs.
Alternative Machine Speeds
Machines can frequently be operated at different speeds, resulting in different rates of product output. However, this usually results in different frequencies of machine downtime. Such situations lead to present economy studies to determine preferred operating speed.
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PRESENT ECONOMY STUDIES
Make Versus Purchase (Outsourcing) StudiesA company may choose to produce an item in house, rather than purchase from a supplier at a price lower than production costs if:
1. Direct, indirect or overhead costs are incurred regardless of whether the item is purchased from an outside supplier, and
2. The incremental cost of producing the item in the short run is less than the supplier’s price
However, there are many noneconomic factors to consider in the make or buy decision. Supplier quality and response time, outsourcing policy of the company, internal capacity utilisation are some of the important factors.
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PRESENT ECONOMY STUDIES
Make Versus Purchase (Outsourcing) Studies
Opportunity costs may become significant when in-house manufacture of an item causes other production opportunities to be foregone (ex: insufficient capacity)
In the long run, capital investments in additional manufacturing plant and capacity are often feasible alternatives to outsourcing.