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Cost definition and classification

Engineering Economy DLSU 2011-2012

Cost estimating
The term is frequently used to describe the process by which the present and future cost consequences of engineering designs are forecast. Used in variety of purposes that includes:
Providing information used in setting a selling prices for quoting, bidding or evaluating contracts. Determining whether a proposed product can be made and distributed at profit

Cost estimating
Evaluating how much capital can be justified for process changes or other improvements. Establishing bechmarks for productivity improvement programs. Approaches: 1. Top-down basically uses historical data form 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, activity level, weight, energy consumption, size, and other factors. This approach is best used early in the estimating process when the alternatives are still being developed and refined.

2. Bottom-up is more detailed method of cost estimating. This method attempts to break down a project into small, manageable units and to estimate their costs and other economic consequences. e.g. A simple example of cost estimating is to forecast the expense of getting a Bachelor of Science (B.S.) from the university you are attending. Suppose the published cost of attending your university is $15,750 for the current year. This figure is anticipated to increase at the rate of 6% per year and includes full-time tuition and fees, university housing, and weekly meal plan. Not included are the costs of books, supplies, and other personal expenses. Initial estimate, these other expenses are assumed to remain constant at $5000 per year.

Break down of anticipated expenses of the typical categories for each of the 4 years at the university. Suppose that the college textbook is $80 and assume you plan on taking 5 courses each semester during first year.
Sum Over Four Years to Obtain Total Cost of a B.S. at Your University 2003 2002

2000 Tuition and fees Books and supplies
books duplication supplies Computer rental Software

Living expenses
rent food clothing recreation utilities

gas maintenance insurance Traffic tickets

tuition Activities fees memberships Medical insurance Lab fees

Classification of costs
Fixed costs are those unaffected by changes in activity level over feasible range of operations for the capacity or capability available.
E.g.: insurance and taxes on facilities, general management and administrative salaries, license fees, and interest costs on borrowed capital.

Variable costs are those associated with an operation that vary in total with the quantity of output or other measures of activity level.
E.g the costs of material and labor used in a product or service are variable costs

Classification of costs
Incremental costs (incremental revenue) is the additional cost, or revenue, that results from increasing the output of a system by one (or more units) and it is often associated with go/no go decisions that involve a limited change in output or activity level.
E.g. incremental cost per mile for driving an automobile may be $0.27, mileage expected for the next major trip, and the age of automobile.

E.g. In connection wit 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 $1.15 per cubic per yard per mile (yd3-mile) to haul the asphalt paving material from the mixing plant to the job location. Factors relating the two mixing sites are as follows (production costs at each site are the same):
Cost factor Average hauling distance
Monthly rental of site Cost to set up and remove equipment Hauling expense

Site A 6 miles
$1,000 $15,000 $1.15/yd3-mile

Site B 4.3 miles

$5,000 $25,000 $1.15/yd3-mile

Note: If site B is selected, there will be an added charge of $96 per day for a flagman.

The job requires 50,000 cubic yards of mixed asphalt paving material. It is estimated that four months (17weeks 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 better site? For the selected site, how many cubic yards of paving material does the contractor have to deliver before starting to make profit if paid $8.05 per cubic yard delivered to the job location?

Classification of costs
Recurring costs are those that are repetitive and occur when an organization produces similar goods or services on a continuing basis.
E.g. in an organization providing architectural and engineering services, office space rental

Nonrecurring costs are those that are not repetitive, even though the total expenditure maybe cumulative over a relatively short period of time.
E.g. the purchase cost for real state upon which a plant will be built

Classification of costs
Direct costs are those that can be reasonably measured and allocated to specific output or work activity.
E.g. the materials needed to make a pair of scissors

Indirect costs are those that are difficult to attribute or allocate to a specific output or work activity. Indirect costs, overhead and burden are used interchangeably.
E.g. the cost of common tools, general supplies, and equipment maintenance in a plant

Classification of costs
Standard costs are representative costs per unit of output that are established in advance of actual production or service delivery. Typical uses:
Estimating future manufacturing costs Measuring operating performance by comparing actual cost per unit with the standard unit cost. Preparing bids on products or services requested by customers Establishing the value of work in-process and finished inventories.

Classification of costs
Cash costs a cost that involves payment of cash Noncash costs/ book costs a cost that does not involve a cash transaction / payments but rather represent the recovery of past expenditures over a fixed period of time.
E.g. depreciation

Classification of costs
Sunk cost is the one that occurred in the past and has no relevance to estimates of future costs and revenues related to an alternative course of action. Opportunity cost - is incurred because of the use of limited resources, such that the opportunity to use those resources to monetary advantage in an alternative use is foregone. Life-Cycle cost refers to the summation of all the costs related to the product, structure, system or service during its life span.

Cost-Volume-Profit Analysis
Total revenue = price x demand TR = pD Where p = (a-bD), hence TR = (a-bD)D = aD - bD2 Total Cost = Fixed cost + Variable cost CT =CF + CV Linear relationship, assume
CV = cvD Where cv is the variable cost per unit

Total revenue
Maximum profit Cost and revenue CT Profit Loss



D* Volume (Demand)

D2 D

Profit (loss) = total revenue total costs Profit = (aD bD2) (CF + cvD) = bD2 + (a-cv)D CF for 0 D a/b and a>0, b>0 Profit occurs when: 1. (a-cv) > 0 2. TR must exceed CT for the period involve

To maximize D: d(profit)/dD = a-cv -2bD = 0 D* = a-cv /2b To ensure maximized profit: d2(profit)/dD2 = -2b Breakeven point Total revenue = total cost aD bD2 = CF + cvD bD2 + (a-cv)D CF = 0

E.g. A company produces an electric timing switch that is used in consumer and commercial products made by several other manufacturing firms. The fixed cost (CF) is $73,000 per month. And the variable cost (cv) is $83 per unit. The selling price unit is p = 180 0.02D. For this situation (a) determine the optimal volume for this product and confirm that a profit occurs (instead of loss) at this demand; and (b) find the volumes at which breakeven occurs; that is what is the domain of profitable demand?