Engineering Economy

Engineering Economy
Chapter 2: Cost Concepts and Design

Economics
Engineering Economy, Fourteenth Edition

By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
Copyright 2009 by Pearson Education, Inc.

Upper Saddle River, New Jersey 07458
All rights reserved.
The objective of Chapter 2 is to

analyze short-term alternatives
when the time value of money is
not a factor.


The Two Cost Estimating Approaches:

Top-Down: uses historical data from similar projects
to estimate the costs, revenues, and other data for the
current project by modifying these data for changes in
inflation or deflation, activity level, weight, energy
consumption, size, and other factors. (Best used at an
early stage when alternatives are being developed)
Bottom-Up: is a more detailed method which
attempts to break down a project into small,
manageable units and to estimate their economic
consequences. These units are added together to
obtain an overall estimate. (Best used at later stages
when detailed output is defined and clarified)

Example 1: Use both approaches to estimate expenses of getting a

4-year BS of Science degree in the US.
Top-down:
Current Year costs $15, 750 (includes tuition, housing, weekly meal
plan). This increases at inflation Rate = 6%
Other costs (books, supplies, personal expenses): stay $5000/year
Year
Tuition,Housing,Meals
OtherExpenses
TotalforYear
$15,7501.06=$16,695
$5,000
$21,695
$16,6951.06=$17,697
$5,000
$22,697
$17,6971.06=$18,759
$5,000
$23,759
$18,7591.06=$19,885
$5,000
$24,885
GrandTotal
$93,036


Bottom-Up:


Costs can be categorized in different ways:

Fixed cost: unaffected by changes in activity
level (ex: insurance, license fees, administrative
salaries, interest on capital)
Variable cost: vary in total with the quantity of
output or similar measure of activity (ex: cost
of material, cost of labor used)
Incremental cost: additional cost resulting from
increasing output of a system by one or more
units (ex: cost of driving an extra mile from
total mileage/year)

Example 2:




More ways to categorize costs

Recurring Costs: those that are repetitive and
occur when an organization produces similar
goods or services on a continuing basis. Variable
costs are also recurring costs, because they repeat
with each unit of output. Fixed costs could also be
recurring (rent is an example).
Nonrecurring Costs: those that are not repetitive,
or occurred over a relatively short period of time.
Example: purchase cost of land to build factory, as
is the cost of construction of the factory itself.

More ways to categorize costs

Direct: can be measured and allocated to a
specific work activity (ingredients to make
a certain product)
Indirect: difficult to attribute or allocate to a
specific output or work activity; also called
overhead or burden (costs of common tools,
utility bills, equipment maintenance)
Standard cost: cost per unit of output,
established in advance of production or
service delivery

Some useful cost terminology

Cash cost: a cost that involves a payment of
cash (buying supplies).
Book cost: a cost that does not involve a
cash transaction but is reflected in the
accounting system (ex: depreciation).
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 (down payment
on a bike then you changed your mind)

More useful cost terminology

Opportunity cost: the monetary advantage
foregone due to limited resources. The cost
of the best rejected opportunity. (Ex:
employee leaves his $20,000/year job for a
year to study and pays $5000 for his studies.
The opportunity cost of going to university is
$25000).
Life-cycle cost: the summation of all costs
related to a product, structure, system, or
service during its life span.

Phases of the Life Cycle & Their Relative Costs


The general price-demand relationship

The demand for a product
or service is directly
related to its price
according to p = a - bD
where p is price, D is
demand, and a and b are
constants that depend on
the particular product or
service.

Total revenue depends on price and

demand.
Total Revenue (TR) is the product of the selling
price per unit, p, and the number of units sold, D.


Calculus can help determine the

demand that maximizes revenue.
Solving, the optimal demand

is


We can also find maximum profit

Profitisrevenueminuscost
TotalCost=FixedCosts+VariableCosts
CT=CF+CV
AtanyDemandD:CV=cv.D
for
Differentiating,wecanfindthevalueofDthatmaximizesprofit:
;secondderivativeofprofitmustbenegative(2b)

And we can find revenue/cost breakeven.

Breakevenisfoundwhentotalrevenue=totalcost.
Solving,wefindthedemandatwhichthisoccurs.
Therearetworootsoftheequation;sotherearetwo
breakevenpoints(D'1andD'2)


Combined Cost and Revenue Functions, and

Breakeven Points as Functions of Volume,
and Their Effect on Typical Profit


Example3:




If Price is Constant (independent of demand)

Single Breakeven Point


Present economy studies can ignore the

time value of money.
Alternatives are being compared over one year or less.
Rule 1: When revenues and other economic benefits
vary among alternatives, choose the alternative that
maximizes overall profitability of defect-free output.
Rule 2: 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.


Example4:







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Chapter 2: Cost Concepts and Design

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

The objective of Chapter 2 is to

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

The Two Cost Estimating Approaches:

Copyright 2009 by Pearson Education, Inc.

Example 1: Use both approaches to estimate expenses of getting a

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Costs can be categorized in different ways:

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

More ways to categorize costs

Copyright 2009 by Pearson Education, Inc.

More ways to categorize costs

Copyright 2009 by Pearson Education, Inc.

Some useful cost terminology

Copyright 2009 by Pearson Education, Inc.

More useful cost terminology

Copyright 2009 by Pearson Education, Inc.

Phases of the Life Cycle & Their Relative Costs

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

The general price-demand relationship

Copyright 2009 by Pearson Education, Inc.

Total revenue depends on price and

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Calculus can help determine the

Solving, the optimal demand

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

We can also find maximum profit

Copyright 2009 by Pearson Education, Inc.

And we can find revenue/cost breakeven.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Combined Cost and Revenue Functions, and

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

If Price is Constant (independent of demand)

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Present economy studies can ignore the

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition

Copyright 2009 by Pearson Education, Inc.