ENGINEERING ECONOMICS (BPK 30902) Chapter 2 FUNDAMENTAL COST CONCEPTS ZUIKARNAIN DAUD
Nov 07, 2014
ENGINEERING ECONOMICS(BPK 30902)
Chapter 2FUNDAMENTAL COST CONCEPTS
ZUIKARNAIN DAUD
Contents
1. Introduction2. Cost Terminology3. Fixed Cost, Variable Costs and Total Costs4. Recurring and Non-recurring Cost5. Direct, Indirect and Standard Costs6. Cash Cost versus Book Cost7. Sunk Cost8. Opportunity Cost9. Life-Cycle Cost
Introduction
Cost terminology and concepts (the meaning and use of various cost terms and concepts) are important in engineering economy (EE) to be understood in order to commutate effectively with order engineering and management personnel
The use of present economy studies in engineering decision making can provide satisfactory results and save considerable analysis effort by considering the various monetary consequences that occur in short time period
Cost Terminology
• A variety of costs that to be considered in EE analysis
• Costs differ in frequency of accurrence, relative magnitude and degree of impact by defining a number of cost categories and illustrate how they should be treated
Fixed Cost, Variable Costs & Total Costs
• Fixed Cost –Unaffected by changes in activity level
feasible range in operation–E.g. Insurance, general management &
admintrative salaries etc
Fixed Cost, Variable Costs & Total Costs
• Variable Cost– Those associated with operation taht vary
in total with quantityof output or other measure of activity level
– E.g. Cost s of material & labor used in a product or service
Fixed Cost, Variable Costs & Total Costs
• Total Costs– Sum of fixed costs & variable cost
Fixed Cost, Variable Costs & Total Costs
Exercise A group of EE study team is making analysis in a
decision to produce a new product in two alternative site. Details are as follows:
Site A Site B
Variable Cost (RM per unit) 1.20 0.90
Fixed Cost (RM per month) 5,000 7,500
Production Capacity (unit per month) 10,000 15,000
Fixed Cost, Variable Costs & Total CostsSolution:The most economic total cost is RM1.40 per unit for site
B due to the higher capacity of production of 15,000 unit per month. If the production is limited to 10,000 units per month, the total cost for Site B per unit is still lower at RM1.65 only compare to site A. However total cost needed for site B is RM21,000 per month compare to site A of RM17,000 per month only.
Site A Site B
Variable Cost ( RM per month 12,000 13,500
Fixed Cost (RM per month) 5,000 7,500
Total Costs (RM per month) 17,000 21,000
Total Cost (per unit) 1.70 1.40
Total Costs at 10,000 unit output 17,000 16,500
Recurring and Nonrecurring Cost
• Recurring Cost– Annual expenses items for direct & indirect cost
associated with five primary resouces – E.g. people, machines, materials, energy &
information - major part expenses
• Non-recurring Cost– Expenses for shutting down operation &
retirement & disposal of assests– E.g. Personnal, materials, transportation etc
Direct, Indirect and Standard Costs
• Direct costs– Costs that can be reasonably measured and
allocated to a specific output or work activity
– E.g. Labour & material costs directly associated with product, service or construction activity
Direct, Indirect and Standard Costs
• Indirect– Costs that are difficult to attribute or
allocate to a specific output or work activity– E.g. Overhead include electricity, general
repairs, supervision etc
Direct, Indirect and Standard Costs
• Standard costs– Planned costs per unit of output that are establised in
advance of actual production or sevice delivery– Developed from anticipated direct labour hours, materials
& overhead categories (level of porduction)
Direct, Indirect and Standard Costs
• Standard costs– Plays an important role & other management
fuctions as• Estimating future manufacturing costs• Measuring operating performace by comparing
actualncost per unitwith standard unit cost• Preparing bid on product or service requested by
customers• Establishing the value of work in process & finised
inventories
Cash Cost versus Book Cost
• Cash cost– A cost that involves payment of cash– Estimated from the prespective establised for the
analysis & are the future expenses inccured for the alternatives be ing analyzed
– In EE analysis , only those costs thats are cash flows or potential cash flows to be considered
Cash Cost versus Book Cost
• Book cost (noncash cost)– A cost that does not involves a cash transaction
and its relected in the accounting system– Represent the recovery of past expenditures over
a fixed period of time– E.g. Depreciation (not a cash flows) charged on
assets such as machines & equipment
Sunk Cost
• Occurred in the past & no relevance to estimate future costs & revenues related to an alternative course of action
• Common to all alternative, is not part of the future cash flows & disregarded in EE analysis
• Non-refundable cash outlays e.g earnest money on a house or money spent on a passport
Sunk Cost
ExampleThe firm is considering to replace of equipment.
Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of replacement sunk cost is RM50,000. However on view is RM20,000 less RM5,000 is RM15,000. Neither RM50,000 or RM15,000 should be consider by EE analyze
Opportunity Cost
• Incurred due to the use of limited resourses for monetary advantage in alternative use if fore gone
• Cost of best rejected opportunity & often hidden or implied
Opportunity Cost
ExampleThe firm is considering to replace of equipment.
Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of EE analysis, even to replace, by keeping the equipment, the new opportunity value of RM5,000 obtain from its disposal
Life-Cycle CostRefers to a summation of all the costs related to a
product, structure, system, or service during its life spin
Begins with identification of the economic need/want & ends with retirement & disposal activities
It is airtime horrizon that must be defined in the context of the specific situation e.g. Highway, engine, aircraft, manufacturing etc
Divided two general time periods; acquisition phase & operation phase
Phase Of The Life-Cycle & Relative Cost
Needs assessment: defination of requirement
Conceptual (preliminary) design: advanced development prototype testing
Details design production or construction planning: facility & resourcesaccquisition
Acquisition Phase
Production or construction
Operation or customer use: maintenance & support
Retirement & disposal
Operation Phase
High
Cost(RM)
0
Potential for life-cycle cost saving
Cumulative commited life-cycle cost
Cumulative life-cycle cost
Time
Life-Cycle Cost - Acquisition phase
• Needs assessment: definition of requirement– Analysis of the economic need/want– Make explicit the requirement for the product, structure,
system or service
• Conceptual (preliminary) design: advanced development prototype testing– Proceed in a logical sequence– Defined technical & operational requirement into
proffered preliminary design
Life-Cycle Cost - Acquisition phase
• Details design production or contruction planning: facility & resource accquisition– Details design & planning for production or construction– Followed by activities necessary to prepare ,acquire &
make ready for operation the facilities & other resources needed
EE studies are an essential part of design process to analyze & compare alternatives & to assist in determing the final details design
Life-Cycle Cost - Operation phase
Production or constructionOperation or customer use: maintenance &
supportRetirement & disposalEE studies priorities1.Achieving efficient & effective support tooperation2.Determining replacement of assets should b occur3.Projecting the timing of retirement & disposal
activities
Life-Cycle Cost - Categories
1. Investment cost– Capital required for most activities in the
acquisition phase– E.g. Single expenditure & series of expenditure
2. Working capital cost– Funds required for the start-up & support of
operational activities – E.g. Material for product/ spare part for
maintenance/ cash for salaries etc
Life-Cycle Cost - Categories
3. Operation & maintenance cost– Includes many of the recurring annual expenses items
associated with operation phase of LC– Direct & indirect cost of operation associated with 5
primary resources (people/machines, materials/ energy/ information
4. Disposal cost– Includes those non-recurring costs of shutting down the
operation & the retirement & disposal of assets at of LC
Quick Revision
• Raw Materials• Direct Labour• Depreciation• Supplies• Utilities• Property taxes• Interest on borrowing
money
• Admin salaries• Payroll taxes• Insurance (building
&equipment)• Clerical salaries• Sales Commissions• Rent
Classify each of the following cost items as mostly fixed or variable
Quiz 1A group of EE team is making analysis in a decision to produce a new product in two alternative site. Details are as follows:
Site A Site B
Variable Cost (RM per unit) 1.40 1.00
Fixed Cost (RM per month) 6,500 9,000
Production Capacity (unit per month at single shift )
10,000 20,000
Calculate:-1.Total Variable Cost (TVC)2.Total Production Cost (TPC) 3.Total Cost (TC)4.Suggest the most economic site for production if the consumer demand is 20, 000 units per month, explain why?
Answer QUIZ 1
Recommendation by EE team:Site B is the most economic site because of lower cost of RM5,500 then
Site A and able to fulfill the consumer demand
Q Site A Site B
1Total Variable Cost (per shift)
VC x TP RM1.40 x 10,000
= RM14,000
VC x TPRM1.00 x 20,000
=RM20,000
2Total Production Cost (per month)
TVC x TPnRM14,000 x 2
= RM28,000
TVC x TPnRM20,000 x 1
= RM20,000
3Total Cost (per month) TPC + FC
RM28,000 + RM6,500 = RM34,500
TPC + FCRM20,000 + RM9,000 =
RM29,000
Thank You