Engineering Economy

Lecture 2: Cost Concepts and Design Economics

Chapter 2

Engineering Economy
Aim of organizations
Organizations want to meet economic needs
and achieve competitive operations 
depends on balancing what is technically
feasible with what is economically acceptable.
Methods of engineering economic analysis
should be used to provide results that will help
to attain an acceptable balance.

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Cost (or Expense) Estimating
The process by which the present and future
cost consequences of engineering designs are
forecast.
Difficulty: Most prospective projects are unique
 difficult to find accurate and relevant past
data to be used in cost estimation.

Engineering Economy
Cost (or Expense) Estimating
Two fundamental approaches for cost
estimating:
Top-down: uses historical data from similar
engineering projects to estimate the costs,
revenues, and other data for the current project by
modifying these data for changes in inflation or
deflation, and other factors.
Bottom-up: more detailed. Attempts to break
down a project into small, manageable units, and
to estimate their costs.

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Fixed, Variable and Incremental Costs
Costs can be categorized in several different
ways:
Fixed cost: unaffected by changes in activity level
Variable cost: vary in total with the quantity of
output (or similar measure of activity)
Incremental cost (marginal cost): additional cost
resulting from increasing output of a system by one
(or more) units  «go/no-go» decisions.

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Recurring and Non-recurring Costs
Recurring costs: costs that are repetitive and
occur when organizations produce similar
goods/services on a continual basis. Variable
costs are recurring costs, and some fixed costs
also.
Non-recurring costs: Those that are non-
repetitive, occur once.

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Direct, Indirect and Standard Costs
Direct: can be measured and allocated to a
specific work activity
Indirect: difficult to attribute or allocate to a
specific output or work activity (also overhead
or burden)
Standard cost: cost per unit of output,
established in advance of production or service
delivery

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Cash Cost vs. Book Cost
Cash cost: a cost that involves a payment of cash.
Book cost (non-cash cost): a cost that does not involve a
cash transaction but is reflected in the accounting system
 depreciation.
In engineering economic analysis only costs that are
cash flows or potential cash flows need to be
considered in the analysis.
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.

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Opportunity Cost, Life-cycle Cost
Opportunity cost: the monetary advantage
foregone due to limited resources. The cost of
the best rejected opportunity.
Life-cycle cost: the summation of all costs
related to a product, structure, system, or
service during its life span (from «needs
assessment» to «retirement/disposal»)
from cradle to grave

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Life-Cycle Cost

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The General Economic Environment
Consumer Goods and Services: Products or
services that are directly used by people to
satisfy their wants/needs  wants/needs
change!
Producer Goods and Services: used to produce
consumer goods or services or other producer
goods or services.
In the long run the amount of producer
goods/services needed is determined by the
amount of needed consumer goods/services

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Measures of Economic Growth
Goods and services are produced and desired
because directly or indirectly they have utility –
the power to satisfy human wants and needs.
Thus they may be used or consumed directly,
or they may be used to produce other goods
and services that may, in turn, be used directly.
Utility is most commonly measured in terms of
value, expressed in some medium of exchange
as the price that must be paid to obtain the
particular item.

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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.

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Necessities vs. Luxuries
Very relative terms
When prices increase:
if it is a luxury good, people tend to forego
More difficult to reduce consumption if it is a necessity
With respect to income:
Normal goods
Superior goods
• Veblen goods
Inferior goods
• Giffen goods

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Competition
Perfect competition
Monopoly
Oligopoly
Duopoly
Monopolistic competition
Monopsony
Oligopsony

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The Total Revenue Function
Total revenue depends on price and demand.
Total revenue is the product of the selling price
per unit, p, and the number of units sold, D

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Finding Total Revenue
Calculus can help determine the
demand that maximizes revenue.

Solving,
the optimal demand is

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Cost, Volume and Breakeven Point
At any demand D, total cost is:
C T = CF + C V
CV = cv * D
Our book gives as two scenarios where
we can calculate breakeven points:
1. Demand is a function of price
2. Price and demand are independent

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1 - Demand as a function of price

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1 - Demand as a function of price

Profit is revenue minus cost, so

for

Differentiating, we can find the value of D that

maximizes profit

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1-Revenue / Cost Breakeven
Breakeven is found when total revenue = total
cost. Solving, we find the demand at which
this occurs:

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Example
Acme Manufacturing is a major player in the lawn sprinkler
business. Their high-end sprinkler is used commercially, and is
quite popular with golf course greens keepers. In producing
these sprinklers Acme’s fixed cost (CF) is $73,000 per month
with a variable cost (cv) of $83 per unit. The selling price for
these high-end sprinklers is described by the equation
p=$180 – 0.02(D).
a) What is the optimal volume of sprinklers? Does Acme
make a profit at that volume?
b) What is the range of profitable demand?

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Example

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Example

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2-Price independent of demand

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Cost Driven Design Optimization
Engineers must consider cost in the design of
products, processes and services.
“Cost-driven design optimization” is critical in
today’s competitive business environment.
In our brief examination we examine discrete
and continuous problems that consider a single
primary cost driver.

Engineering Economy
Cost Driven Design Optimization
For cost-driven design optimization problems,
two main tasks are as follows:
Determine the optimal value for a certain
alternative’s design variable
Select the best alternative, each with its own
unique value for the design variable

Cost models are developed around the design

variable, X.

Engineering Economy
Cost Driven Design Optimization
In general cost models consist of three types of costs:
Fixed costs
Costs that vary directly with the design variable
Costs that vary indirectly with the design variable

where,
a is a parameter that represents the directly varying cost(s),
b is a parameter that represents the indirectly varying cost(s),
k is a parameter that represents the fixed cost(s), and
X represents the design variable in question (e.g. Weight, velocity, etc.)

Engineering Economy
Cost Driven Design Optimization
Optimizing a design with respect to cost is a
four-step process:
1) Identify the design variable that is the primary cost driver.
2) Express the cost model in terms of the design variable.
3) For continuous cost functions, differentiate to find the
optimal value. For discrete functions, calculate cost over a
range of values of the design variable.
4) Solve the equation in step 3 for a continuous function. For
discrete, the optimum value has the minimum cost value
found in step 3.

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Present Economy Studies
When alternatives for accomplishing a specific task are
being compared over one year or less and the influence
of time on money can be ignored, engineering economic
analyses are referred to as present economy studies:
When revenues and other economic benefits vary
among alternatives, choose the alternative that
maximizes overall profitability of defect-free output.
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.

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Example
After machining, the finished volume of a certain
metal part is 0.17 cubic inch
Data for two types of metal being considered for
manufacturing the part are given below:

Determine the cost per part for both types of

material and recommend which material to use

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Solution
Brass:
• Labor: (0.64 min/pc)($12.00/hr)(1 hr/60 min) = $0.128/pc
• Material: ($0.96/lb) (0.31 lb/ in3 ) (0.3 in3 ) -(0.3 in3 / pc - .17 in3 /
pc)($0.24/lb)(0.31 lb/in3)= $0.079/pc
• Total Cost = $0.207/pc
Aluminum:
• Labor: (0.42 min/pc)($12.00/hr)(1 hr/60 min) = $0.084/pc
• Material: ($0.52/lb - $0.00/lb)(0.10 lb/in3) (0.45 in3)= $0.023/pc
• Total Cost = $0.107/pc
(Choose Aluminum to minimize total cost)

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Present Economy Studies

Alternative Machine Speeds

Operate at different speeds, resulting in different
rates of product output
Lead to present economy studies to determine
preferred operating speed

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Present Economy Studies
Make Versus Purchase Studies
if:
• Direct, indirect or overhead costs are incurred
regardless of whether the item is purchased from an
outside supplier, and
• The incremental cost of producing the item in the
short run is less than the supplier’s price
The relevant short-run costs of the make versus
purchase decisions are the incremental costs
incurred and the opportunity costs of resources

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Example
The company is currently purchasing a part and is
considering manufacturing the part in-house
This company is not operating at full capacity, and no
other use for the excess capacity is contemplated
Unit costs are given below:

Should the part be made in-house or purchased?

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Solution
Assumptions:
• Utilizing the excess capacity has no opportunity costs
• This product will not change fixed overhead for the plant
Solution: Focus on differences - what really changes?

The incremental cost to make the product in-house is actually

$3.75 per unit versus $7.50 to purchase

Engineering Economy