Engineering Economics

Presented by
Dr. Zahoor

Lecture 2
 Course topics and schedule
Week Topic Reading

Introduction, Study Skills , Engineering Economics, Decision Making Pro

1 Chapter 1
cess
2 Cost Concept Chapter 2
Chapter 18,
3 Accounting systems, Balance Sheet, Income sheet
Handouts
4 Time value of Money Chapter 3

5 Interest and Equivalence Chapter 2

7 Rate of Return Chapter 7

8 Deprecation Chapter 11

9 Profit Centre Analysis Hand outs

10 Financial Analysis Chapter 8,9

11 Cash Flow Analysis Chapter 12

12 Benefit Cost Analysis Chapter 9

13 Financing Chapter 16

14 Financial Decision Making Chapter 17

15 Project Presentations

16 Final Exam
 Engineering Costs
• Evaluating a feasible alternative requires that many costs be
analyzed
•Initial investment
•New construction
•Facility modification
•General labor
•Parts and materials
•Inspection and quality
•Fixtures and tooling
•Data management
•Technical support 3
3
 What is a Cost?

• Use of company resources (such as cash or cash-equivalent

value) to provide future company benefit
• Measured by resource given up
• Example
•Buy Equipment for $2,000, cost = $2,000,
• future benefit = use of equipment

4
4
 What is an Expense?

Part of Cost which is “used up” for purpose of generating

revenue
• Example
Buy Equipment for $2,000,
cost = $2,000,
expense = $500 per year (assume 4 year life)

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5
 Costs
Costs:
Fixed and Variable Cost Indices
 Direct and Indirect
 Marginal and Average Estimating Benefits
 Sunk and Opportunity
 Recurring and Non- Cash Flow Diagrams
Recurring
 Incremental
Cash and Book
 Life-Cycle

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 Direct and Indirect Costs

Direct costs Indirect costs

• Costs that can be
easily and conveniently
traced to a unit of product or
other cost object.
• Examples: direct material
and direct labor
• Costs that cannot be easily
and conveniently traced to
a unit of product or other
cost object.
• Example: manufacturing
overhead….office supplies

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 Product Costs in Manufacturing
• Direct Materials (direct cost) – materials that are physically
and conveniently traced to the product being made

• Direct Labor (direct cost)– labor costs of employees that are

physically and conveniently traced to the product being made

•Example: Charges of carpenter

• Manufacturing Overhead (indirect cost) – all other costs of

the product not physically and conveniently traced to the
product.
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Examples of Manufacturing Overhead Costs

• Indirect Materials – materials that are part of a product, but

the costs are not easily or conveniently traced to the product.

Measure amount of glue and sand paper used in making a chair

• Indirect Labor – labor costs of a product that are not easily or

conveniently traced to the product. Cost of various people such

as for supervisors, material handlers, design engineers

• Other Factory or Production Costs such as utilities,

depreciation, insurance, etc.

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Cost Classifications for Predicting Cost Behavior

How a cost will react to the

changes in the level of
activity within the relevant
range.
– Total variable costs
change when activity
changes.
– Total fixed costs remain
unchanged when activity
changes.

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 Total Variable Cost
Your total mobile network telephone bill is based on how
many minutes you talk.
The total bill varies with the number of minutes used
Total Long Distance
Telephone Bill

Minutes Talked
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 Variable Cost Per Unit
Variable costs change in total as the activity level rises and falls,
variable cost per unit is constant. Cost per long distance
minute talked is constant.
For example, 10 cents per minute.

Telephone Charge
Per Minute

12
Minutes Talked
 Total Fixed Cost
Total fixed cost is constant within the relevant range.
Your monthly basic telephone bill probably does not change
when you make calls on PTCL nos.
Telephone Bill
Monthly Basic

Number of PTCL Calls

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 Fixed Cost Per Unit
On a per unit basis, a fixed cost is inversely related to activity.
Average fixed cost per local call decreases as more local
calls are made.

Monthly Basic Telephone

Bill per Local Call

Number of Local Calls

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 Engineering Costs

Marginal - variable cost for the next unit

• Depends on the next unit

Average - total cost/number of units

• Rent+ food+…+n/number of units

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 Engineering Costs and Cost Estimating

Key Question: Where do the numbers come from that we use in

engineering economic analysis?

• Cost estimating is necessary in an economic analysis

• When working in industry, you may need to consult with

professional accountants to obtain such information
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Engineering Costs and Cost Estimating
Example 2-1. Albert’s Charter Bus Venture
Albert plans to charter a bus to take people to see a wrestling match
show in Jacksonville. His wealthy uncle will reimburse him for his
personal time, so his time cost can be ignored.

Item Cost Item Cost

Bus Rental $80 Ticket $12.50
Gas Expense $75 Refreshments $ 7.50
Other Fuel Costs $20
Bus Driver $50

Total Costs $225.00 Total Costs $20.00

• Which of the above are fixed and which are variable costs?
• How do we compute Albert’s total cost if he takes n people to
Jackonville?
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Albert’s Charter Bus Venture (example)

• Answer: Total Cost = $225 + $20 n.

Graph of Total Cost Equation:

Total cost

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 Albert’s Charter Bus Venture (example)
Marginal cost (marginal tax)
-The cost to take one more person
Average cost
- Average cost: the cost per person
Avg. Cost = TC/n
Avg. Cost = ($225+$20n)/n

– For n = 30, TC = $885

Avg. Cost = $885/30 = $29.50

Total cost cannot be calculated

from an average cost value

For n =35, TC  35*($29.50) = $ 1,032.50 19

 Albert’s Charter Bus Venture (example)
Marginal and Average Costs

$300.00

$250.00

$200.00
Average
Cost

$150.00 Marginal
Trip Ticket
$100.00

$50.00

$0.00
1 3 5 7 9 11 13 15 17 19 21 23
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Number of People
 Albert’s Charter Bus Venture (example)
Question: Do we have enough information yet to decide how much money
Albert will make on his venture? What else must we know?
– Albert needs to know his total revenue
– Albert knows that similar ventures in the past have charged $35 per
person, so that is what he decides to charge
– Total Revenue = 35n (for n people)
Total profit = Total Revenue – Total Cost:
35n – (225 + 20n) = 15n – 225
Question:
How many people does
Albert need to break even?
(not lose money on his venture)

Solve 15 n – 225 = 0 => n=15

more than 15, he makes money
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 Albert’s Charter Bus Venture (example)
Albert's Charter Bus Venture

$1,000.00

$800.00

$600.00
Total Cost

$400.00 Cost
Revenue
$200.00 Profit

$0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23
($200.00)

($400.00)
Number of People 22
 Albert’s Charter Bus Venture (example)
Where is the Loss Region?. Where is the Profit Region?. Where is the
Breakeven point?. Can you make this chart in Excel?
Albert's Charter Bus Venture

$1,000.00

$800.00

$600.00
Total Cost

$400.00 Cost

Reven

$200.00
Profit

$0.00
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23

($200.00)

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($400.00)
 Sunk Costs
A sunk cost is money already spent due to a past decision.
– As engineering economists we deal with present and future
opportunities
– We must be careful not to be influenced by the past
– Disregard sunk costs in engineering economic analysis
Example:
Suppose that three years ago your parents bought you a laptop
PC for $2000.
– How likely is it that you can sell it today for what cost?
– Suppose you can sell the laptop today for $400. Does the
$2000 purchase cost have any effect on the selling price
today?
The $2000 is a sunk cost. It has no influence on the present
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opportunity to sell the laptop for $400.
 Opportunity Cost
• An opportunity cost is the benefit that is foregone by engaging
a business resource in a chosen activity instead of engaging
that same resource in the foregone activity.
• Example: Suppose your wealthy uncle gives you $75,000 when
you graduate from high school. It is enough to put you through
college
(5 years at $15,000 per year). It is also enough for you to open
a business making web pages for small companies instead of
going to college. You estimate you would make $20,000 per
year with this business.

– If you decide to go to college you give up the

opportunity to make $20,000 per year
– Your opportunity cost is $20,000
– Your total cost per year is $35,000 25
 Sunk and Opportunity Cost
Example 2-3. A distributor has a case of electric pumps. The
pumps are unused, but are three years old. They are becoming
obsolete. Some pricing information is available as follows.

Item Amount Type of Costs

Price for case 3 years ago $7,000 Sunk cost

Storage costs to date $1,000 Sunk cost

List price today for a case of Can be used to help
new and up to date pumps $12,000 determine what the lot is
worth today.
Amount buyer offered for case
2 years ago $5,000 A foregone opportunity

Case can currently be sold for $3,000 Actual market value today
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 Recurring and Non-Recurring Costs
Recurring costs are those expenses that are known, anticipated,
and occur at regular intervals. These costs can be modeled as
cash flows.
Non-recurring costs are one-of-a-kind and occur at irregular
intervals. They are difficult to plan for or anticipate.
• Example. You decide to landscape a ground and then care for
it. Which are recurring and which are non-recurring costs you
incur?
– Remove existing trees, vegetation
– Have land graded with bulldozer
– Have yard planted with grass
– Plant shrubs, trees
– Mow grass
– Fertilize grass, shrubs
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– Water grass, shrubs
 Incremental Cost
• Incremental Cost is the additional cost that results from:
– Increasing the output of a system by one (or more) units
– Selecting one alternative over another
Example 2-4. Philip can choose between model A ( a budget
model) or model B (with more features). The following
information is available.
Cost Items Model A Model B Incremental
Cost of B
Purchase price $10,000 $17,500 $7,500
Installation cost $3,500 $5,000 $1,500
Annual maintenance cost $2,500 $750 $-1,750/yr
Annual utility expense $1,200 $2,000 $800/yr
Disposal cost after useful life $700 $500 $-200

•Can we conclude that model B is more expensive than model A?

 Cash Costs vs. Book Costs
Cash costs
require the cash transaction of dollars from “one pocket to
another”.
Book costs
are cost effects from past decisions that are recorded in
the books (accounting books) of a firm
– Do not represent cash flows
– Not included in engineering economic analysis
– One exception is for asset depreciation (used for tax
purposes).

Example: You might use Edmond’s Used Car Guide to

conclude the book value of your car is $6,000. The book
value can be thought of as the book cost. If you actually
sell the car to a friend for $5,500, then the cash cost to
your friend is $5,500. 29
 Life-Cycle Costs

Life-cycle costs are the summation of all costs, both

recurring and nonrecurring, related to a product,
structure, system, or service during its life span

Products go through a life cycle, just like people

– Assessment & Justification Phase

– Conceptual or Preliminary Design Phase
– Detailed Design Phase
– Production or Construction Phase
– Operational Use Phase
– Decline and Retirement Phase
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 Life-Cycle Costs
Life Cycle Cost Chart
% Total L.C. Cost

120.00%
100.00% L.C. costs
80.00% committed
60.00%
40.00% L.C. costs
20.00% spent
0.00%
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Project Phase 31
Life-cycle design cost

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 Life-Cycle Costs
Comments:
• The later design changes are made in the life-cycle, the
higher the costs.
• Decisions made early in the life-cycle tend to “lock in”
costs incurred later in the life cycle:
Nearly 70 to 90% of all costs are set during the
design phases, while only 10 to 30% of the cumulative
life-cycle costs have been spent.

• Question. When is the best time to consider all life-cycle

effects, and make design changes?

• Bottom Line. Engineers should consider all life-cycle

costs when designing products and the systems that
produce them.
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 Cost Indices
• The Pakistan government publishes cost index data through the
State Bank of Pakistan.

• The best-known example is the consumer price index (CPI), a

measure of inflation.
– The measure is scaled, so it is only the relative values of any two
measures that are meaningful.
– For example, in 1920, the measure was about 20; in 1997 it was
about 160. The conclusion is that one would have to spend
160/20, or 8 times as much in 1997 as in 1920 for the same
consumables.
• Cost indices work in the same way as price indices.

• Cost indices are dimensionless.

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 Estimating Benefits
For the most part, we can use exactly the same approach to
estimate benefits as to estimate costs:
– Fixed and variable benefits
– Recurring and non-recurring benefits
– Incremental benefits
– Life-cycle benefits
– Rough, semi-detailed, and detailed benefit estimates
– Difficulties in estimation
– Segmentation and index models

Major differences between benefit and cost estimation:

– Costs are more likely to be underestimated
– Benefits are most likely to be overestimated
– Benefits tend to occur further in the future than costs 35
 Example – Assignment 1
Two summer Camps have the following data for a 12-week
session:
Camp A Camp B
Charge per camper $120 per week Charge per camper $100 per week
Fixed costs $48,000 per session Fixed costs $60,600 per session
Variable cost per camper $80 per week Variable cost per camper $50 per week
Capacity 200 campers Capacity 150 campers

a. Develop the mathematical relationships for total cost and total

revenue for camp A
b. What is the total number of campers that will allow camp B to
break even?

c. What is the profit or loss for the 12-week session if camp A

operates at 80% capacity?

d. Determine the breakeven number of campers for the two 36

camps to have equal total costs for a 12-week session.
 Cash Flow Diagrams
• Cash flow diagrams (CFD)
summarize the costs and
benefits of projects
• A CFD illustrates the size, sign,
and timing of individual cash
flows
• Periods may be months,
quarters, years, etc.
Example:
Time Period Size of Cash Flow
0 (today) Receive $100 (positive CF)
1 Pay $100 (negative CF)
2 Positive CF of $100
3 Negative CF of $150
4 Negative CF of $150
5 Positive CF of $50

COMMENTS: Tomorrow

• The end of one period is the

100 100
beginning of the next one
50
• Arrows point up for revenues or
benefits, down for costs
• One person’s payment (cash 0 1 2 3 4 5
outflow with -ve sign) is another
person’s receipt (cash inflow with
+ve sign) 100
Today
It is essential to use only one 150 150 37
perspective in any CFD
38
Fixed Cost & Variable Cost Industry
 Fixed cost industry
 revenue dollars contain more than 50 percent fixed costs
 airlines, computer software developers, & restaurants

 To pay this high percentage of fixed cost, they must sell a relatively
high volume

 Variable cost industry

 revenue dollars contain less than 50 percent fixed costs
 service businesses
 Insurance firms
 Computer software companies
 Material distributors
 Rental equipment companies

 In these companies the majority of their business cost is

caused by their sales volume.
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Business Implications of Fixed Cost Structure
 The nature of a specific business will have a lot to do with
defining its inherent fixed cost structure.
 Airlines have historically been burdened with high fixed
costs related to
 maintenance, contractual labor agreements
 computer reservation systems
 aircraft
 Airlines struggled during lean years because they are
unable to cover fixed costs.
 During boom years these same companies are extremely
profitable because costs do not rise (much) with increases
in volume. Basically, there is not much cost difference in
flying a plane empty or full! 40
Avoid Fixed Costs
 Other businesses attempt to avoid fixed costs so that
they can maintain a more stable stream of income
relative to sales
 For example, a computer company might outsource
its tech support
 Rather than having a fixed staff that is either idle or
overloaded at any point in time, they simply pay an
independent support company a per-call fee
 The effect is to transform the organization's fixed
costs to variable

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Economies of Scale
 This means that certain efficiencies are achieved as
production levels rise.
 Fixed costs can be spread over larger production runs
and this causes a decrease in the per unit fixed cost.
 In addition, enhanced buying power might result
(e.g., quantity discounts) as volume goes up, and this
can actually reduce the per unit variable cost. These
are valid considerations.

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Committed Fixed Costs
 Committed Fixed Costs arise from an
organization's commitment to engage in
operations
 These elements include such items as
 depreciation, rent,
 insurance, property taxes
 These costs are not easily adjusted with
changes in business activity

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Discretionary Fixed Costs
 Discretionary Fixed Costs originate from top
management's yearly spending decisions
 Examples of discretionary fixed costs include
 advertising, employee training
 Proper planning can result in avoidance of these costs if
cutbacks become necessary or desirable

Committed fixed costs relate to desired long-run positioning

of firm,whereas discretionary fixed costs
have short-term orientation

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MIXED COSTS
 Many costs contain both variable and fixed
components. These costs are called mixed or
semi variable.
 Cell phone agreements usually provide for a
monthly fee plus usage charges for excess
minutes, text messages, and so forth.
 With a mixed cost, there is usually some fixed
amount, plus a variable component tied to an
activity.

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Example— Accept a Special Offer
 A customer has offered you $ 15.00 for 5,000 units of your
product. You normally sell your product for $ 25.00. Should you
accept this offer?

 You currently produce and sell 40,000 units with a maximum

capacity of 50,000 units.
 Total manufacturing costs are $ 18.00 per unit, consisting of
$ 12.50 variable and $ 5.50 fixed.

 Change in Revenues $ 75,000 (5,000 x $ 15.00)

 Change in Expenses ( 62,500) (5,000 x $ 12.50)

 Net Change $ 12,500

 Conclusion: You should accept the special offer since it results in

$ 12,500 of additional income.

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Contribution Margin

47
Contribution Margin
 Contribution margin :
 revenues minus variable expenses
 Contribution margin is a conceptual number reflecting
amount available from each sale, after deducting all
variable costs associated with the units sold
 Some of these variable costs are product costs, &
some are selling & administrative in nature
 Contribution margin is generally a number calculated
for internal use and analysis

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Contribution Margin: Aggregated/per Unit/ratio

 Case in Point: Leyland Sports, a manufacturer of

score board signs.
 The production cost is $500 per sign, and Leyland
pays its sales representatives $300 per sign
sold. Thus, variable costs are $800 per sign.
 Each signs sells for $2,000.
 Leyland's contribution margin is $1,200 ($2,000 -
($500 + $300)) per sign.
 In addition, Assume that Leyland incurs $1,200,000
of fixed costs, regardless of the level of activity

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 Contribution Margin
Assume 1,000 units are produced and sold

Total Per Unit Ratio

100%
Sales (1,000 X $2,000) $2,000,000 $2,000
800 40%
Variable costs (1,000 X $800) 800,000

$1,200,000 $1,200 60%

Contribution Margin
Fixed costs 1,200,000
Net income -0-

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 What would happen if Leyland sold 2,000 units?

Total Per Unit Ratio

100%
Sales (2,000 X $2,000) $4,000,000 $2,000
800 40%
Variable costs (2,000 X $800) 1,600,000
$1,200 60%
Contribution Margin $2,400,000
Fixed costs 1,200,000
Net income $1,200,000

51
 What would happen if Leyland sold only 500 units?

Total Per Unit Ratio

$2,000 100%
Sales (500 X $2,000) $1,000,000.
800 40%
Variable costs (500 X $800) 400,000.
$1,200 60%
Contribution Margin $ 600,000.
Fixed costs 1,200,000.
Net loss $(600,000)

 changes did not impact fixed costs, or change the per unit
or ratio calculations
 1,000 units achieved breakeven net income.
 At 2,000 units, Leyland managed to achieve a $1,200,000
net income
 500 units resulted in a $600,000 loss.
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A picture is worth a thousand words

53
 Graphic Presentation

Dollars are represented on vertical axis and units on horizontal

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Interpretation
 The total sales line starts at "0" and rises $2,000
for each additional unit.
 The total cost line starts at $1,200,000 (reflecting
the fixed cost), and rises $800 for each additional
unit (reflecting the addition of variable cost).
 "Break-even" results where sales = total costs
 At any given point, the width of the loss area (in
red) or profit area (in green) is the difference
between sales and total costs.

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Outsourcing versus Insourcing

Outsourcing is Insourcing is
purchasing goods producing goods
and services from or providing services
outside vendors within the organization

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or

57
Currently, a firm manufactures the dashboards that it
uses in making automobiles. The cost of
manufacturing this part is summarized below. An
outside supplier has offered to provide the part for
$240. Should the car manufacturer accept the offer?

Direct materials $ 80
Direct labor 80
Variable factory overhead 52
Fixed factory overhead 68
Total cost per unit $280

INITIAL REACTION—DON’T MAKE

INTERNALLY 58
 Proposal to Manufacture Automobile Part
February 15, 2006
Purchase price of part $240.00
Cost to manufacture:
Direct materials $80.00
Direct labor 80.00
Variable factory overhead 52.00 212.00
Cost savings from manufacturing part $ 28.00

The fixed factory overhead is excluded

because it is not relevant—so continue
making the part.
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THANKS

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