EUT 444 : Pengurusan

Kejuruteraan /
Engineering Management

Cost Concepts
analyzing And
short-term alternatives Design
when
value of money is not a factor
the time

Economics
1-1
Engineering decision which based on economy
(money) criteria

Profit = Revenue - Cost

1-2
 Contents
• Basic Terminology of Cost and
Revenue
• Law of Supply and Demand
• Cost, Production Volume, and
Breakeven Point Relationships
• Economic Breakeven Point
• Point of Maximum Profit
• Cost Estimation Techniques
1-3
1.0 Cost Terminology
An amount that has to be paid or given
up in order to get or produce something.
Generally, cost is usually a monetary
valuation
• Effort of; • Material
• Resources • Time and utilities consum
• Risks incurred
• Missing or forgone opportunity

1-4
1.1 Accounting Cost (Book)
versus Analytical Cost (Cash)
Accounting cost is a cost which does not involve a cash
transaction and is reflected in the accounting system,
such as an anticipated saving due to certain proactive
measures taken in product manufacturing or the
opportunity lose.
• Opportunity Cost and Actual Cost
Analytical costCost
• Explicit is aand
costImplicit
that involves
Cost payment of cash
(and results in a cash flow)
• Fixed and Variable Cost
• Total, Average and Marginal Costs
• Incremental and Sunk Costs
1.2 Fixed And Variable 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 capital cost, general
management
The cost youand haveadministrative
to pay when salaries, license fees,
you produce
and interest costs on borrowed capital.
nothing
Variable costs are those associated with an operation
that vary in total with the quantity of output or other
measures of activity level (operating cost).
Example of variable costs include : costs of material
and labour used in a product or service, because they
FIXED + VARIABLE COST = TO
𝐹𝐶 + 𝑉𝐶 = 𝑇𝐶

1-7
 Short Run Production/Out
Cost TC

TVC
Optimum output level
TFC

Quantity of Output
1.3 Incremental (Marginal) Cost
/Incremental
Revenue Cost = the additional cost (or revenue)
that results from increasing the output of a system by
one (or more) units.

Considered in long production run

1-9
Example 1
In connection with surfacing a new highway, a contractor has a choice of two sites on which to
set up the asphalt-mixing plant equipment. The contractor estimates that it will cost $2.75 per
cubic yard mile (yd3-mile) to haul the asphalt-paving material from the mixing plant to the job
location. Factors relating to the two mixing sites are as follows (production costs at each site
are the same):

The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated that four
months (17 weeks of five working days per week) will be required for the job. Compare the
two sites in terms of their fixed, variable, and total costs. Assume that the cost of the return
trip is negligible. Which is the better site? For the selected site, how many cubic yards of
paving material does the contractor have to deliver before starting to make a profit if paid $12
per cubic yard delivered to the job location?
1-10
Solutio
The fixed and variable costs for this job are indicated in the table shown next. Site rental,
n
setup, and removal costs (and the cost of the flagperson at Site B) would be constant for the
total job, but the hauling cost would vary in total amount with the distance and thus with the
total output quantity of yd3-miles (x).

Site B, which has the larger fixed costs, has the smaller total cost for the job. Note that the
extra fixed costs of Site B are being “traded off” for reduced variable costs at this site.

The contractor will begin to make a profit at the point where total revenue equals total cost as
a function of the cubic yards of asphalt pavement mix delivered. Based on Site B, we have;

3($2.75) = $8.25 in variable cost per yd3 delivered

Total cost (fixed cost + variable cost = total revenue)
$90,750 + $8.25x = $12x; Solving for x, x = 24,200 yd3 delivered.

Therefore, by using Site B, the contractor will begin to make a profit on the job after
delivering 24,200 cubic yards of material. How much is the profit?
1.4 Direct, Indirect, and
Standard
Direct costs areCosts
costs that can be reasonably measured
and allocated to a specific output or work activity. The
labor and material costs directly associated with a
product, service, or construction activity are direct
costs. For example, the materials needed to make a pair
of scissorscosts
Indirect wouldarebe a direct
costs cost.difficult to allocate to a
that are
specific output or work activity. Normally, they are
costs allocated through a selected formula (such as
proportional to direct labor hours, direct labor dollars,
or direct material dollars) to the outputs or work
activities. For example, the costs of common tools,
general supplies, and equipment maintenance in a
 Indirect cost examples
• Utilities
Direct cost examples • IT systems and networks
• Physical assets • Purchasing
• Maintenance and • Management
operating costs (M&O) • Taxes
• Materials • Legal functions
• Direct human labor • Warranty and guarantees
(costs and benefits) • Quality assurance
• Scrapped and reworked • Accounting functions
product • Marketing and publicity
• Direct supervision of
Standard costs are planned costs per unit of output
that are established in advance of actual production or
service delivery. They are developed from anticipated
direct labor hours, materials, and overhead categories
(with their established costs per unit).

Standard costs play an important role in cost control

and other management functions
1.5 Sunk Cost
Sunk Cost is one that has occurred in the past and
cannot be recovered. It has no relevance to estimates of
future costs and revenues related to an alternative
course of action. Thus, a sunk cost is common to all
alternatives, is not part of the future (prospective) cash
flows, and can be disregarded in an engineering
economic analysis. For instance, sunk costs are
nonrefundable cash outlays, such as earnest money on
a house or money spent on a passport.
1.6 Life-Cycle Cost (LCC)
Life-cycle cost is the summation of all costs,
both direct and indirect, recurring and
nonrecurring, related to a product,
infrastructure, system, or service during its
life span.
Product life cycle begins with the
identification of the economic need or
want (feasibility/market study, product
specifications, R&D activities) and ends
with the retirement and disposal activities.
1.6.1 Life-Cycle Cost Analysis
Principle Cost unaffected by the change in the
level of production activities ;
• Capital cost
• Management / admin salaries
Fixed Cost • Licence fees
• R&D • Interest on borrowed capital
• Init investment Recurring and
• Infrastructure Nonrecurring Cost 5 phases
• Design Product Life-Cycle • Development
• Manufacturing Cost • Introduction
• Testing Direct and • Growth
• Depreciation Indirect Cost
• Disposal
• Maturity
Variable Cost • Decline

Cost that vary with the quantity of the

produced output;
Green technology requirement; • Raw materials
• Materials selection • Labor etc
• Eco-friendly processes
• Reusability, recycling
1.7 Total Cost, Average Cost And
Marginal Cost
Average Cost (cost to produce 1 unit of product)
= Total Cost / Total Number of Produced Unit
𝑇𝐶
𝐴𝐶 =
𝑄

Marginal Cost = the change in the Total Cost that

arises when the quantity produced is incremented by
one unit, that is, it is the cost of producing one more
unit of a good Δ𝑇𝐶
𝑀𝐶 =
Δ𝑄
Output Fixed Variable Total Margina Av. Av. Var. Av.
Q Cost Cost, Cost l Cost, Fixed Cost Cost
FC VC C MC Cost, AVC = AC =
AFC = VC/q TC/Q
FC//Q
0 48 0 48
1 48 25 73 25 48 25 73
2 48 46 94 21 24 23 47
3 48 66 114 20 16 22 38
4 48 82 130 16 12 20.5 32.5
5 48 100 148 18 9.6 20 29.6
6 48 120 168 20 8 20 28
7 48 141 189 21 6.9 20.1 27
8 48 168 216 27 6 21 27
9 48 198 246 30 5.3 22 27.3
10 48 230 278 32 4.8 23 27.8
11 48 272 320 42 4.4 24.7 29.1
MC < AC : AC decreases MC = AC : AC at the min
MC > AC : AC increases
1.8 Total Revenue, Average Revenue
And Marginal Revenue
What is Revenue ?
Revenue – payment in terms of money which is
received by the seller (or company) from sale of
product or services to the buyer (or consumer)

1-21
Handbag Producer
Various model with different prices

No of bags sold Price of bag (RM) Total Revenue

(RM)
1 20 20
1 30 50
1 40 90
1 50 140
1 60 200

Total revenue (TR) – Total money

received from
the sale of all products 1-22
No of bags sold Price of bag Total Revenue
(RM) (RM)
1 20 20
1 30 50
5
1 40 90
1 50 140
1 60 200

Average revenue (AR) = TR / No of units sold

= 200 / 5 = 40

1-23
No of bags sold Price of bag Total Revenue
(RM) (RM)
1 20 20 Net addition to
TR
1 30 50 = 90 – 50 = 40= 50 – 20 = 30
1 40 90
1 50 140
1 60 200

Marginal revenue (MR) = Net addition to TR when one

unit is sold.
MR = Change in TR / change in quantity
sold = ∆ TR / ∆Q
1-24
1.9 Relationship Between Total Revenue
And Marginal Revenue
Bag Total Price Margina Total
sold bag of bag l revenue
TR increases when MR
sold revenue TR is maximum when
1 1 20 20 20 TR decreases when MR
1 2 25 25 45
MR is positive
1 3 30 30 75
1 4 15 15 90
MR = 0
1 5 0 0 90
MR = -ve
1 6 -10 -10 80

Cost > selling price

1-25
2.0 Law Of Supply and
Demand
Economic Activity

money
Buyer revenue to the seller Seller

Product
 2.1 Law of Demand (Consumer)

Demand – Different quantities that people are

willing and able to buy at different prices.
b is the amount by which demand increases
for each unit decrease in p.
P Qd
for 0 ≤ D ≤ a/b
𝒑 = 𝒂 − 𝒃𝑫 (𝟏)
P and a > 0, b > 0,
𝑎−𝑝
𝐷= ;𝑏 ≠ 0
𝑏
P Qd
Q
D (unit of Demand)
General Price–Demand
Relationship.
There is another situation (economic model) where price
is independent on demand.
2.2 Law of Supply (Producer)

Supply – Different quantities that firms are

willing and able to produce at different prices.

Qs P
P

Qs P
Q
S (quantity supplied)

Direct relationship between price and quantity

supplied
2.3 Total Revenue Function

The total revenue, TR, that will result from a

business venture during a given period is the
product of the selling price per unit, p, and the
number of units sold, D.
𝑇𝑅 = 𝑝𝑟𝑖𝑐𝑒 × 𝑑𝑒𝑚𝑎𝑛𝑑 = 𝑝. 𝐷 (2)
for 0 ≤ D ≤ a/b
𝑇𝑅 = 𝑎 − 𝑏𝐷 . 𝐷 = 𝑎𝐷 − 𝑏𝐷2 (3) and a > 0, b > 0,
 Solving Eq (3) If we keep selling the
same product

The demand, Ð that will produce maximum TR

can be obtained by solving;
𝑑𝑇𝑅
= 𝑎 − 2𝑏𝐷 = 0 (4)
𝑑𝐷
Therefore;
𝑎
Ð= (5)
2𝑏
Note : due to cost–volume relationships most businesses would not obtain maximum
profits by maximizing revenue (maximum TR) i.e Maximum revenue does not mean
maximum profit.
3.0 Cost, Volume, and Breakeven
Point Relationships
Revenue
RM110 (profit)
Producer Cost to produce product
RM100 Break even
RM90 (loss)

Break even point is the point when the total

revenue earned by
a producer is equal to the total cost incurred
by him. 1-31
Unit of Total Total cost Profits
output revenue
10 200 210 -10
20 Total240 Total245 profits-5
Unit of
output30
revenue cost TR = TC (break ev
280 280 0
10 200 210 -10
40 320 315 5
20 240 245 -5
50 360 340 20
30 280 280 0
60 400 390 10
40 320 315 5
70 440 435 5

Break even occurs at 30 units of output

At any demand D, total cost is

𝑇𝐶 = 𝑇𝐹𝐶 + 𝑇𝑉𝐶 (6)

With the assumption

𝑇𝑉𝐶 = 𝐶𝑣 . 𝐷 (7)

Where Cv is variable cost per unit (TVC/quantity produced).

When TR function is combined with Eq (6) and (7).

TC

Total Revenue
function

TFC

Breakeven Point
(TR=TC)

• At Breakeven Point D′1 (TR=TC), an increase in demand

will result in a profit for the operation.
• At optimal demand, D∗, profit is maximized (TR-TC at the
greatest amount).
• At breakeven point D′2, total revenue and total cost are
again equal, but additional volume will result in an
operating loss instead of a profit
3.1 Point of Maximum Profit
Profit = total revenue (TR) − total costs (TC). other approach is when
MR = MC
From Equations (3), (6) and (7)

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑎𝐷 − 𝑏𝐷2 − TFC + 𝐶𝑣 𝐷 (8)

𝑃𝑟𝑜𝑓𝑖𝑡 = −𝑏𝐷2 + 𝑎 − 𝐶𝑣 𝐷 − 𝑇𝐹𝐶 (9)

we can find the optimal demand (D* point) at which maximum profit
will occur by taking the first derivative of Eq(9) with respect to D
and setting it equal to zero: i.e. no additional profit when the volume
is increased.
𝑑(𝑝𝑟𝑜𝑓𝑖𝑡)
= 𝑎 − 𝐶𝑣 − 2𝑏𝐷 = 0 (10)
𝑑𝐷
Therefore, the optimum value of D that maximizes profit is;
𝑎 − 𝐶𝑣
𝐷∗ = (11)
2𝑏
3.2 Economic Breakeven Point
Total revenue (TR) = Total costs (TC) (Breakeven Point)
From Equations (3), (6) and (7)

𝑎𝐷 − 𝑏𝐷2 = 𝑇𝐹𝐶 + 𝐶𝑣 𝐷 (12)

−𝑏𝐷2 + 𝑎 − 𝐶𝑣 𝐷 − 𝑇𝐹𝐶 = 0 (13)

Solving a quadratic equation yield;

2 1/2
− 𝑎 − 𝐶𝑣 ± [(𝑎 − 𝐶𝑣 ) −4(−𝑏)(−𝑇𝐹𝐶)]
𝐷′ = (14)
2(−𝑏)
Example 2
A company produces an electronic timing switch that is used in consumer and commercial
products. The fixed cost (TFC) is $73,000 per month, and the variable cost (Cv) is $83 per
unit. The selling price per unit is p = $180 − 0.02(D), based on Equation (1). For this situation,

(a) determine the optimal volume for this product and the profit earned at optimum production
level.

(b) find the volumes at which breakeven occurs; that is, what is the range of profitable
demand?

Solutio
n
a) The optimal volume i.e production point with maximum profit is given by Equation (11)
𝑎 − 𝐶𝑣 180 − 83
𝐷∗ = = = 2,425 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ.
2𝑏 2(0.02)

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡 = 𝑎𝑑 − 𝑏𝐷2 − (𝑇𝐹𝐶 + 𝐶𝑣 𝐷)

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑎𝐷 − 𝑏𝐷2 − 𝑇𝐹𝐶 + 𝐶𝑣 𝐷 =

[180 2425 − 0.02 2425)2 − [73,000 + 83 2425 = 44,612

A demand of D∗ = 2,425 units per month results in a maximum profit of $44,612

per month.
A company produces an electronic timing switch that is used in consumer and commercial
products. The fixed cost (TFC) is $73,000 per month, and the variable cost (Cv) is $83 per
unit. The selling price per unit is p = $180 − 0.02(D), based on Equation (1). For this situation,

(b) find the volumes at which breakeven occurs; that is, what is the range of profitable
demand?

Solutio
b) Total revenue = total cost (breakeven point) (13)
n −𝑏𝐷 + 𝑎 − 𝐶
2
𝑣 𝐷 − 𝑇𝐹𝐶 = 0
−0.02𝐷2 + 180 − 83 𝐷 − 73,000 = 0
−0.02𝐷2 + 97𝐷 − 73,000 = 0
2 −4(−0.02)(−73,000)]1/2
−97 ± [(97)
𝐷′ =
2(−0.02)
−97 + 59.74
𝐷′1 = = 932 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ
−0.04
−97 − 59.74
𝐷′2 = = 3,918 𝑢𝑛𝑖𝑡 𝑝𝑒𝑟 𝑚𝑜𝑛𝑡ℎ
−0.04
Breakeven occurs at production point of 932 units per month.
While the range of profitable demand is 932–3,918 units per month.
4.0 Cost Estimation
Cost estimation is important in all aspects of a project, but especially in the stages
of project conception, preliminary design, detailed design, and economic analysis.
When a project is developed in the private or the public sector, questions about
costs and revenues will be posed by individuals representing many different
functions: management, engineering, construction, production, quality, finance,
safety, environmental, legal, and marketing, to name some.

In engineering practice, the estimation of costs receives much more attention

than revenue Estimation.
4.1 Purposes of Cost Estimation
1. Providing information used in setting a selling
price for quoting, bidding, or evaluating contracts

2. Determining whether a proposed product can be

made and distributed at a profit (for simplicity, price
= cost + profit)

3. Evaluating how much capital can be justified for

process changes or other improvements

4. Establishing benchmarks for productivity

improvement programs
4.2 Cost Estimation Aproach
Top-Down Approach – Based on historical data: 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.

This
Bottomapproach is best -used
Up Approach earlydetailed
A more in the method
estimating
of
process when alternatives
cost estimating. are breaks down a project
This method
still
into being developed
small, and refined.
manageable units and estimates their
economic consequences. These smaller unit costs are
added together with other types of costs to obtain an
overall cost estimate.
 Refer Example 3.1 in the textbook (Page 69) –
example of top-down and bottom up approach.

Integrated Approach– A more complete approach

including WBS, classification and comprehensive
economical model (we do not cover in this course)
 4.3 Accuracy of Cost
Estimates General guidelines for accuracy
Conceptual/Feasibility stage – order-of-magnitude
estimates are in range of ±20% of actual costs
Detailed design stage - Detailed estimates are in
range of ±5% of actual costs

Characteristic curve of accuracy vs. time to make estimates

4.4 Cost Estimation
Models
1. Cost Indexed

2. Unit Method

3. Factor
 4.4.1 Cost Indexes (or Ratio Technique)
 Definition: Cost Index is ratio of cost today to cost in the past
• Indicates change in cost over time; therefore, they account for the
impact of inflation
• Index is dimensionless
• CPI (Consumer Price Index) is a good example

Formula for total

cost is
Formula for total cost is
Example: Cost Index Method
Problem: Estimate the total cost of labor today in US dollars for a
maritime construction project using data from a similar project in
Europe completed in 1998.
Labor index, 1998: 789.6 Cost in 1998: €3.9 million
Labor index, current: 1165.8 Currently, 1 € = 1.5 US$

Solution: Let t = today and 0 = 1998 base

Ct = 3.9 million × (1165.8/789.6) = €5.76 million

= €5.76 × 1.5 = $8.64 million
 4.4.2 Unit Method
 Commonly used technique for preliminary design stage estimates
 Total cost estimate CT is per unit cost (u) times number of units (N)
CT = u × N
 Example uses:
 Cost to operate a car at 60¢/mile for 500 miles: CT = 0.60 × 500 = $300
 Cost to build a 250 m2 house at $2250/m2: CT = 2250 × 250 = $562,500

 Cost factors must be updated periodically to remain timely

When several components are involved, estimate cost of each component

and add to determine total cost estimate CT
 4.4.3 Factor Technique

The factor technique is an extension of the unit

method in which we sum the product of several
quantities or components and add these to any
components estimated directly.
Problem 1 (Answer: Total cost = $1,227,250
(3.15) In a building construction project,
7,500 feet of insulated ductwork is required.
The ductwork is made from 14-gauge steel
costing $8.50 per pound. The 24-inch-
diameter duct weighs 15 pounds per foot.
Insulation for the ductwork costs $10 per
foot. Engineering design will cost $16,000,
and labor to install the ductwork will
amount to $180,000.

What is the total cost of the installed

Problem 2 (Answer: Estimated cost = $1,274
(3.16) A biotech firm is considering
abandoning its old plant, built 23 years ago,
and constructing a new facility that has 50%
more square footage. The original cost of the
old facility was $300,000, and its capacity in
terms of standardized production units is
250,000 units per year.

The capacity of the new laboratory is to be

400,000 units per year. During the past 23
years, costs of laboratory construction have
Problem 3 (Total cost with options = $354,8
(3.11) The purchase price of a natural gas-
fired commercial boiler (capacity X) was
$181,000 eight years ago. Another boiler of
the same basic design, except with capacity
1.42X, is currently being
considered for purchase. If it is purchased,
some optional features presently costing
$28,000 would be added for your
application.

If the cost index was 162 for this type of

Problem 4 (Answer = 4,497 units)
(3.35) Given the following information, how
many units must be sold to achieve a profit
of $25,000? [Note that the units sold must
account for total production costs (direct
and overhead) plus desired profit.]
Direct labor hours: 0.2 hour/unit
Direct labor costs: $21.00/hour
Direct materials cost: $4.00/unit
Overhead costs: 120% of direct labor
Packaging and shipping: $1.20/unit
Selling price: $20.00/unit