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Engineering Cost

Week 4

Evaluating a set of feasible alternatives requires that many costs be analyzed. Examples include costs for initial investment, new construction, facility modification, general labor, parts and materials, inspection and quality, training , computer hardware and software, material handling, tooling, data management, and technical support, as well as general support costs (overhead).

Types of Costs
Fixed Costs & Variable Costs Marginal Costs & Average Costs Sunk Costs & Opportunity Costs Recurring & Non-recurring Costs Incremental Costs Cash Costs & Book Costs Life-Cycle Costs

Fixed Costs and Variable Costs


Fixed Costs: constant, independent of the output or activity level.
Property taxes, insurance Management and administrative salaries License fees, and interest costs on borrowed capital Rental or lease

Variable Costs: Proportional to the output or activity level.


Direct labor cost Direct materials

Breakeven Analysis
Total Variable Cost = Unit Variable Cost * Quantity Total Cost = Fixed Cost + Total Variable Cost Total Revenue = Unit Selling Price * Quantity Breakeven point: the output level at which total revenue is equal to total cost. Applications of Breakeven analysis:
Determining minimum production quantity Forecast production profit / loss

Breakeven Analysis
$
Profit
Total Revenue Total Costs

Variable Costs

Fixed Costs Loss

Break-even Point

Production Quantity

Marginal Costs and Average Costs


Marginal Costs: the variable cost for one more unit of output
Capacity Planning: excess capacity Basis for last-minute pricing

Average Costs: total cost divided by the total number of units produced.
Basis for normal pricing

Sunk Costs & Opportunity Costs


Sunk Costs: Cost that has occurred in the past and has no relevance to estimates of future costs and revenues related to an alternative
Purchasing price of current equipment in deciding new equipment (except for capital gain/loss consideration)

Opportunity Costs: Cost of the foregone opportunity and is hidden or implied


Existing equipment in replacement analysis

Past (Sunk) Costs VS Future (Opportunity) Costs


Sunk cost - money spent due to a past decision. We cannot do anything about these costs.
Purchase price paid for a car two years ago.

Opportunity cost - a benefit that is foregone by engaging a resource in a chosen activity instead of engaging that same resource in some other activity. We make a choice or decision.
Buying lunch instead of DVD.

Which amount is the value at present?

Example
A distributor of electric pumps must decide what to do with a "lot" of old electric pumps that was purchased 3 years ago. Soon after the distributor purchased the lot, technology advances were made. These advances made the old pumps less desirable to customers. The pumps are becoming more obsolescent as they sit in inventory. The pricing manager has the following information.

Which amount is the value at present?


Example 3

Price when purchased Storage costs List price when purchased Current list price of new pumps Amount offered for pumps 2 years ago Current price that the pumps could be sold for

$ 7,000.00 Sunk cost Past decisions $ 1,000.00 Sunk cost Past decisions $ 9,500.00 Old list Past decisions $ 12,000.00 New list dif erent features Past decisions $ 5,000.00 Foregone opportunity Past decisions $ 3,000.00 Market value Present opportunity

Recurring Costs and Non-recurring Costs


Recurring Costs: Repetitive and occur when a firm produces similar goods and services on a continuing basis
Office space rental

Non-recurring Costs: Not repetitive, even though the total expenditure may be cumulative over a period of time
Typically involve developing or establishing a capability or capacity to operate Examples are purchase cost for real estate and the construction costs of the plant

Incremental Costs
Incremental Costs: Difference in costs between two alternatives.
Suppose that A and B are mutually exclusive alternatives. If A has an initial cost of $10,000 while B has an initial cost of $14,000, the incremental initial cost of (B - A) is $4,000.

Brain storming

Example Choosing between Model A & B


Which Plan you will prefer (A or B)? Cost Items Purchase Price Installation Costs Annual Maintenance Annual Utility Disposal Cost Model A Model B $10,000 $17,500 3,500 2,500 1,200 700 5,000 750 2,000 500 Incremental Cost $7,500 1,500 -1,750 800 -200

We will prefer Model B


Because the

Annual Maintenance and Disposal cost


of Model B is less than Model A

Life-Cycle Costs
Life-Cycle Costs: Summation of all costs, both recurring and nonrecurring, related to a product, structure, system, or service during its life span. Life cycle begins with the identification of the economic needs or wants (the requirements) and ends with the retirement and disposal activities.

Example
A Blue Ray tourist Company gathered the following data about a bus service for tourists. Fixed cost Variable cost
Bus Rental $80 Gas Expense 75 Other fuel 20 Bus driver 50 Event ticket (per person) $12.50 Refreshment(per person) $7.5

Total fixed cost $225

Total variable cost 20$ per person

Total cost = $225 + $ 20 (per person) Now to calculate total cost for any number of people: Let number of people are = x Variable Cost x number of people = 20x Now total cost = $225 + 20x If the ticket is raised to $35 If no of people = x The total revenue will be = 35 x
To find at least howexpenses many people(x=?) will be needed in order to just cover?

Total cost =Total revenue


$225 + 20 x = 35 x 225 = 35 x 20 x 225 = 15 x 15 x = 225 X = 225/15

X= 15 (this is called break even point)


So in $35 ticket per person , at least 15 people will be needed to cover the expenses.

Example
$1000 Profit
$800 Total Revenue = 35X Total Costs = $225 + 20X Variable Costs = 20X

$600
$400 $200 $0 Loss

Fixed Costs = $225

10

15

20

25

X # of Customers

Breakeven Point

The level of business activity at which the total costs to provide the product, good, or service are equal to the revenue (or savings) generated by providing the service. This is the level at which one "just breaks even."
Total Revenue = 35X

$1000 Profit
$800

Total Costs = $225 + 20X Variable Costs = 20X

$600
$400 $200 $0 Loss

Fixed Costs = $225

10

15

20

25

X # of Customers

Profit region
$1000 Profit
$800 Total Revenue = 35X Total Costs = $225 + 20X Variable Costs = 20X

$600
$400 $200 $0 Loss

Fixed Costs = $225

10

15

20

25

X # of Customers

The output level of the variable x greater than the breakeven point, where total revenue is greater than total costs.

Loss region
$1000 Profit
$800 Total Revenue = 35X Total Costs = $225 + 20X Variable Costs = 20X

$600
$400 $200 $0 Loss

Fixed Costs = $225

10

15

20

25

X # of Customers

The output level of the variable x less than the breakeven point, where total costs are greater than total revenue.

Cash Costs vs. Book Costs


Cash costs - movement of money from one owner to another - also known as a cash flow.
Payment this month on an auto loan.

Book cost - cost of a past transaction that is recorded in an accounting book.


Down payment recorded in your checkbook from last years automobile purchase.

COST ESTIMATING Engineering economic analysis focuses on the future consequences of current decisions. Because these consequences are in the future, usually they must be estimated and cannot be known with certainty. Examples of the estimates that may be needed in engineering economic analysis include purchase costs, annual revenue, yearly maintenance, interest rates for investments, annual labor and insurance costs, equipment salvage values, and tax rates.

Why to Estimate Cost?


Estimating is the foundation of economic analysis. As is the case in any analysis procedure, the outcome is only as good as the quality of the numbers used to reach the decision. For example, a person who wants to estimate her federal income taxes for a given year could do a very detailed analysis, including social security deductions, retirement savings deductions, itemized personal deductions, exemption calculations, and estimates of likely changes to the tax code.

Types of Estimate
Rough estimates: Rough estimates are estimates with little detail or accuracy. These estimates require minimum resources to develop, and their accuracy is generally

-30% to +60%.

Semi detailed estimates:


The are used for budgeting purposes at a project's conceptual or preliminary design stages. These estimates are more detailed, and they require additional time and resources to develop. Greater sophistication is used in developing Semi detailed estimates than the roughorder type, and their accuracy is generally

-15 to +20%.

Detailed estimates:
The are used during a projects detailed design. These estimates are made from detailed quantitative models, blueprints, product specification sheets, and vendor quotes. Detailed estimates involve the most time and resources to develop and thus are much more accurate than rough or semi detailed estimates. The accuracy of these estimates is generally -3

to +5%.

Estimating Benefits
So far we have focused on cost terms and cost estimating. However, engineering economists must often also estimate benefits. Example benefits include sales of products, revenues from bridge tolls and electric power sales, cost reductions from reduced material or labor costs, reduced time spent in traffic jams, and reduced risk of flooding. These benefits are the reasons that many engineering projects are undertaken. The cost concepts and cost estimating models can also be applied to economic benefits.

Problem

Two new rides are being compared by a local amusement park in terms of their annual operating costs. The two rides ALFA ,BETA are assumed to be able to generate the same level of revenue (and thus the focus on costs). The ALPHA has fixed costs of $10,000 per year and variable costs of $2.50 per visitor. The BETA has fixed costs of $4000 per year, and variable costs of $4 per visitor. Provide answers to the following questions so the amusement park can make the needed

comparison.
(a) Mathematically determine the breakeven number of visitors per.

(b)

See the figure below:

Solution : (a) x = number of visitors per year


Break-even when: Total Costs (Alpha) = Total Costs (Beta) $10,000 + $2.5 x = $4,000 + $4.00 x x = 400 visitors is the break-even quantity

Y1 (Tug)

Y2 (Buzz)

0
4,000 8,000

10,000
20,000 30,000

4,000
20,000 36,000