Engineering Economics

and Cost Systems

Session 9
Prof. Frame
11/21/2016
 Outline

• Important Dates
• Engineering Economics
• Decision Making
• Depreciation
• Break
• Cost Systems
 Important Dates
Monday (11/28) Thursday (12/1) Friday (12/2)
• 11/29 – no class 9:00
9:30
10:00
Make an appointment 10:30 Siddhu
to meet with me to 11:00 Rahul
discuss your 11:30

productivity project. 12:00

12:30
1:00
This meeting is in lieu 1:30

of class, and it will 2:00

2:30
count as part of your
3:00
participation grade. 3:30
4:00
4:30
 Important Dates
• 12/6 – Half of the class will be dedicated to
review for the final exam. Come prepared
with your questions.

• 12/6 – Productivity Reports Due by midnight.

• 12/15 – Final Exam

1:45 – 3:45 pm in Carlson 108
 Engineering Economics
• Evaluate monetary consequences of
products, projects, and processes that
engineers design

• Adjust for the time value of money

• Make engineering and manufacturing

decisions based on monetary
consequences
 Time Value of Money
NOW FUTURE

Interest rate is an exchange

rate for time value of money
 Decision Making Principles
• Common Measure – Put everything in Dollar Terms
• Consider Everything – Even if it cannot be
quantified, it must be considered
• Differences Matter – Only consider the differences
among options, and ignore sunk costs.
• Separate the decisions – Don’t make decisions
contingent on each other if you don’t have to.
• Systems Viewpoint - Make decisions that help the
company, not just one department.
• Common Planning Horizon – Compare options
over the same time period.
• Uncertainty – Most economic data are based on
future consequences of current decisions. Address
uncertainty explicitly.
 Decision Making Process

Define the Problem:

• Ask the right questions
• Pull information from many sources
• Not too narrow, not too broad

Define Objectives Alternatives Evaluate Select Implement Audit

 Decision Making Process

Choose the Objectives:

• How will the options be evaluated?
• Consider the time value of money
• Consider uncertainty and risk

Define Objectives Alternatives Evaluate Select Implement Audit

 Decision Making Process
Identify Alternatives:
• Brainstorming options & solutions
• No idea is discounted yet
• Creativity is essential

Define Objectives Alternatives Evaluate Select Implement Audit

 Decision Making Process
Evaluate Consequences:
• Cursory Evaluation
• Detailed Evaluation
• Consider long-term and interdepartmental consequences

Define Objectives Alternatives Evaluate Select Implement Audit

 Decision Making Process
Select the Best Alternative:
• Selection Criteria are based on
the Identified Objective
• Usually depends on more than
just cost

Define Objectives Alternatives Evaluate Select Implement Audit

 Decision Making Process

Implementing the Solution / Alternative:

• Requires strategy & plan
• Easier if “stakeholders” are
involved in the entire process

Define Objectives Alternatives Evaluate Select Implement Audit

 Decision Making Process

Audit the Result:

• How accurate was predicted performance?
• Opportunity to refine forecasts and models
• Opportunity for continuous improvement

Define Objectives Alternatives Evaluate Select Implement Audit

 Decision Making Process

Define Objectives Alternatives Evaluate Select Implement Audit

Analysis Paralysis
 Analysis Paralysis
• Ask the right questions
• Know when to stop (or shift) your
research
 Operational Economics
Time Value of Money vs Money Value of Time
• Recurring vs nonrecurring costs
• More than once vs one-time
• Life-cycle costs
• Purchase, use, repair, sale
• Fixed vs variable costs
• “all-or-nothing” vs volume dependent
• Average vs marginal vs incremental costs
• Total cost / # of units vs cost for one more unit vs cost for
specified number of units
• Direct vs indirect vs overhead costs
• Labor & material per unit vs utilities, insurance, maintenance
vs allocated cost for sales, admin, and management
Depreciation
 Depreciation
• Due to deterioration or obsolescence
• As equipment (and tangible assets) value
decreases over time, the business can
claim the decrease in value of the
equipment as an expense for tax
purposes.
• Value:
• Decline in market value of an asset
• Decline in value of an asset to its owner
• Systematic allocation of an asset’s cost over its
depreciable life
 Amortization
• Businesses can claim the decrease in
worth of intangible assets as well.
(Patents, trademarks, customer
relationships).
 Depreciation and Amortization
• Accounting entries (not cash flow)
• Cost is spread out over a defined period of time
• Claimed amount not necessarily constant over time
 Depreciation Methods
B – Cost of Asset
• Classic Methods S – Salvage Value
N – Depreciable Life (yrs)
• Straight-line dt – Annual depreciation charge
𝑩−𝑺 t – year
𝒅𝒕 = dj – depreciation charges to date
𝑵

• Sum-of-years’-digits (SOYD)
𝑵−𝒕+𝟏
𝒅𝒕 = (𝑩 − 𝑺)
𝑺𝑶𝒀𝑫

• Double Declining Balance

𝒕−𝟏
𝟐
𝒅𝒕 = 𝑩 − ෍ 𝒅𝒋
𝑵
𝒋=𝟏
 Depreciation Methods
• MACRS – Modified Accelerated Cost
Recovery System
• Simplified the process of claiming depreciation
values
• IRS publishes Property Class and Recovery
Period tables (IRS Publication 946)
• MACRS percentage rate (rt) is determined from
property class and recovery period

𝒅𝒕 = 𝑩 × 𝒓𝒕
Break
COST SYSTEMS
 Cost Accounting System Overview

• A job order cost system provides a

separate record for the cost of each
quantity of product that passes through
the factory.
• A particular quantity of product is termed
job.
• Manufacturers that use a job order cost
system are sometimes called job shops.
 Cost Accounting System Overview

• Under a process cost system, costs are

accumulated for each of the departments
or processes within the factory.
• A process system is best suited for
manufacturers of units of product that are
not distinguishable from each other
during a continuous production process.
 Factory Overhead Cost
• Factory overhead includes all
manufacturing costs except direct
materials and direct labor.
• Factory overhead includes such items as
indirect materials, indirect labor, factory
power, and factory depreciation.
 Period Costs
• Period costs are expenses that are used
in generating revenue during the current
period and are not involved in the
manufacturing process.
• Period costs are generally classified into
two categories: selling and
administrative.
 Summary of Cost Flows
Costs & Expenses
Product Costs Balance Sheet
Materials Materials
Purchases Inventory

Direct
Work in Cost of goods
Labor
Process manufactured
Factory Inventory
Overhead
Finished
Goods
Inventory
 Summary of Cost Flows
Costs & Expenses
Product Costs Balance Sheet
Materials Materials
Purchases Inventory Period costs flow
directly to the
Direct
Work in income statement
Labor
Process
Factory Inventory
Overhead
Income Statement
Finished
Goods Cost of
Period Costs Inventory Goods Sold
Selling and Selling and
Administrative Administrative
Job Order Costing for Decision Making

• Job order costing can be used to evaluate

an organization’s cost performance.
• The unit costs for similar jobs can be
compared over time to determine if costs
are staying within expected ranges.
• If costs increase for some unexpected
reason, the details in the job cost sheets
can help discover the reason.
 Comparing Job Order and Process
Cost Systems

Job Order Process

WIP inventory is sum of job cost WIP inventory consists of partially
sheets of partially completed jobs completed production in a
department
MFG costs are accumulated to jobs MFG costs are accumulated to
departments
Accumulate product costs
Categorize MFG costs (direct material, direct labor, factory overhead)
Allocate costs to products
Maintain WIP and finished goods inventory records
Use product cost data for decision making
Process cost systems are used to
manufacture homogeneous
products. Examples are:
 Tennis balls
 Motor oil
 Candy bars
 Soft drinks
In contrast, job cost systems are
used to manufacture unique
products or provide unique services.
Examples are:
 Custom-built homes
 Landscape design services
 Customer cabinets
 Airplanes (767)
 Cost of Production Report
• A cost of production report is normally
prepared for each processing department at
periodic intervals (usually monthly).
• The cost of production report provides the
following production quantity and cost data:
• The units for which the department is accountable and
the disposition of those units.
• The production costs incurred by the department and
the allocation of those costs between completed and
partially completed units.
Cost of Production Reports
Holland Beverage Company—Blending Department
For the Months Ended April 30 and May 31, 2008
April May
Direct materials $ 20,000 $ 40,600
Direct labor 15,000 29,400
Energy 8,000 20,000
Repairs 4,000 8,000
Tank cleaning 3,000 8,000
Total $ 50,000 $ 106,000
Units completed / 100,000 / 200,000
Cost per unit $ 0.50 $ 0.53
Per-Unit Expense Comparisons
Cost Allocation and Activity-
Based Costing
 Single Factory Overhead Rate
Method

• Under the single plant-wide factory

overhead rate method, all of the factory
overhead is allocated to all products,
using only one rate.
 Ruiz Company Illustration
• Ruiz Company manufactures two
products, snowmobiles and lawnmowers.
• Both products are manufactured in a
single factory.
• There is $1,600,000 of factory overhead
budgeted for the period.
• Ruiz Company plans to manufacture
1,000 units of each product.
• Assume snowmobiles and lawnmowers
both require 10 direct labor hours per unit
to manufacture.
 Computing Single Plantwide
Factory Overhead

Total budgeted factory overhead costs

Total budgeted plant-wide allocation base

$1,600,000 $80 per direct

= labor hour
20,000 direct labor hours

(1,000 x 10 dlh) + (1,000 x 10 dlh)

Snowmobile:
$80 per dlh x 10 direct labor hours = $800
Lawnmower:
$80 per dlh x 10 direct labor hours = $800
Single Plant-wide Factory Overhead
Rate Method—Ruiz Company

The greatest advantage

of the single plant-wide
overhead rate method is
that it is simple and
inexpensive to apply in
practice.
 Multiple Production Department
Factory Overhead Rate Method

• The multiple production department

factory overhead rate method uses
different rates for each production
department to allocate factory overhead
to products.
Comparison of Single Plant-wide Rate
and Multiple Prod. Dept. Rate Methods
Production Department Factory
Overhead Rates and Allocation

Fabrication Department Overhead Rate:

$1,030,000
= $103 per dlh
10,000 direct labor hours

Assembly Department Overhead Rate:

$570,000
= $57 per dlh
10,000 direct labor hours
Allocating Factory Overhead to
Products—Ruiz Company
Multiple Production Department
Rate Method—Ruiz Company

$938 $662

What is the overhead rate?

 Distortion in Product Costs—Single
Plant-wide versus Multiple Production
Department Factory Overhead Rates

Factory Overhead Cost per Unit

Single Plantwide Multiple Production

Rate Department Rates

Snowmobile $800 $938

Lawnmower 800 662
Activity-Based Costing (ABC) Method

• The activity-based costing (ABC) method

allocates factory overhead more
accurately than does the multiple
production department rate method.
• The activity-based costing method uses
cost of activities to determine product
costs.
• Under this method, factory overhead
costs are initially accounted for in activity
cost pools.
 Multiple-Production Department Factory
Overhead Rate Method vs. Activity-Based Costing
 Ruiz Company Example

Activity Cost Pool Amount

Fabrication $ 530,000
Assembly 70,000
Setup 480,000
Quality control inspection 312,000
Engineering changes 208,000
Total budgeted factory overhead $1,600,000
 Activity Rates & Activity Base
• The activity cost pools are assigned to
products, using factory overhead rates
for each activity.
• These rates are often called activity rates.
• Activity rates are determined by dividing
the cost budgeted for each activity pool
by the estimate activity base.
• This base is related to an activity pool.
Estimated Activity-Base Usage
Quantities—Ruiz Company
 Ruiz Company
Budgeted Estimated
Activity Amount Activity Rate
Fabrication $ 530,000 / 10,000 dlh = $ 53
Assembly 70,000 / 10,000 dlh = $ 7
Setup 480,000 / 120 setups = $ 4,000
Quality control
inspections 312,000 / 104 inspects. = $ 3,000
Engineering
changes 208,000 / 16 changes = $13,000
Total $1,600,000

Cost Drivers
 Budgeted Estimated
Activity Amount Activity Rate
Fabrication $ 530,000 / 10,000 dlh = $ 53
Assembly 70,000 / 10,000 dlh = $ 7
Setup 480,000 / 120 setups = $ 4,000
Quality control 312,000 / 104 inspts. = $ 3,000
Engineering 208,000 / 16 changes = $13,000
Total $1,600,000
Fabrication: DL Hours Rate Total
Snowmobile 8,000 $53 $424,000
Lawnmower 2,000 53 106,000
Total 10,000 $530,000
 Budgeted Estimated
Activity Amount Activity Rate
Fabrication $ 530,000 / 10,000 dlh = $ 53
Assembly 70,000 / 10,000 dlh = $ 7
Setup 480,000 / 120 setups = $ 4,000
Quality control 312,000 / 104 inspts. = $ 3,000
Engineering 208,000 / 16 changes = $13,000
Total $1,600,000
Assembly: DL Hours Rate Total
Snowmobile 2,000 $7 $14,000
Lawnmower 8,000 7 56,000
Total 10,000 $70,000
 Budgeted Estimated
Activity Amount Activity Rate
Fabrication $ 530,000 / 10,000 dlh = $ 53
Assembly 70,000 / 10,000 dlh = $ 7
Setup 480,000 / 120 setups = $ 4,000
Quality control 312,000 / 104 inspts. = $ 3,000
Engineering 208,000 / 16 changes = $13,000
Total $1,600,000
Setup: Setups Rate Total
Snowmobile 100 $4,000 $400,000
Lawnmower 20 4,000 80,000
Total 120 $480,000
 Budgeted Estimated
Activity Amount Activity Rate
Fabrication $ 530,000 / 10,000 dlh = $ 53
Assembly 70,000 / 10,000 dlh = $ 7
Setup 480,000 / 120 setups = $ 4,000
Quality control 312,000 / 104 inspts. = $ 3,000
Engineering 208,000 / 16 changes = $13,000
Total $1,600,000
Quality Control: Inspts Rate Total
Snowmobile 100 $3,000 $300,000
Lawnmower 20 3,000 12,000
Total 104 $312,000
 Budgeted Estimated
Activity Amount Activity Rate
Fabrication $ 530,000 / 10,000 dlh = $ 53
Assembly 70,000 / 10,000 dlh = $ 7
Setup 480,000 / 120 setups = $ 4,000
Quality control 312,000 / 104 inspts. = $ 3,000
Engineering 208,000 / 16 changes = $13,000
Total $1,600,000
Engineering: Changes Rate Total
Snowmobile 12 $13,000 $156,000
Lawnmower 4 13,000 52,000
Total 16 $208,000
Cost Allocation Summary:
Activity Snowmobile Mower Total
Fabrication $ 424,000 $106,000 $ 530,000
Assembly 14,000 56,000 70,000
Setup 400,000 80,000 480,000
Quality control 300,000 12,000 312,000
Engineering 156,000 52,000 208,000
Total $1,294,000 $306,000 $1,600,000
Budgeted units 1,000 1,000
Cost per unit $1,294 $306
Activity-Based Costing Method—Ruiz
Company
 Distortion in Product Costs

Factory Overhead Cost per Unit—Three Cost Allocation Methods

Single Plant-wide Multiple Production

Rate Department Rates ABC
Snowmobile $ 800 $ 938 $1,294
Lawnmower 800 662 306
 Activity-Based Costing (ABC)

•Focus on process costs & cost drivers

•More detailed cost structure
•Manage rather than allocate overhead
 ABC Justification
• More accurate costs provide more
accurate prices & more profit
• Over-priced  less likely to get the order
• Under-priced  more likely to get order & lose
money
 For next class
• CASE STUDY:
• Reading – Sustainable Manufacturing:
• Stevenson 4.7
• Jha Ch. 16 (CANVAS)
• HW
• Due by midnight 12/6
• Productivity Report
 References For this Lecture
Eschenbach, T. (2011) Engineering Economy. New York: Oxford
University Press.
Monden, Y. (2012) Toyota Production System: An Integrated Approach to
Just-in-Time, 4th Ed. New York: CRC Press.
Newman, D., Lavelle, J., Eschenbach, T. (2014) Engineering Economic
Analysis, 12th Ed. New York: Oxford University Press.
Warren, C., Reeve, J., Duchac, J. (2015) Financial & Managerial
Accounting, 13th ed. Boston: Cengage.