Cost concepts and design

economics
Dr. P. I. Ayantha Gomes

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• Fixed and variable costs
• Fixed costs are those unaffected by the change in
activity level (cost does not change with the number of
units produced)
• Stepped fixed cost: fixed cost remains same up to a
particular out put, however if output changes in several
folds, fixed cost can get affected. E.g. Store room rent is
Rs 100,000, the space can be enough to store up to
5000 units, if the production increased up to 7000
units, obviously additional space is needed. And that
can be used up to another production level

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Factory rent is Rs 100,000 per month (this is a fixed cost)
Material cost per chair is Rs 3000 (this is a variable cost), lets assume 100 chairs were made

Total fixed cost = Fixed cost =Rs 100,000 Total variable cost = variable cost per unit * No
of units =3000*100 = Rs 300,000

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• Example: 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. He estimates that it
will cost 1.15 USD/cubic yard 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 cost 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
the cost of 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 8.05 USD/cubic yard delivered to the job location?

Cost Factor Site A Site B

Average hauling distance 6 4.3
(miles)
Monthly rental of site 1000 5000
(USD)
Cost to set up and remove 15,000 25,000
the equipment (USD)
Hauling expense 1.15 1.15
(USD/cubic yard-mile)
Flagperson (USD/day) Not required 96
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# The following cost terms also fit into fixed and variables costs explained before

• Direct, indirect and standard costs

– Costs that can be reasonably measure and allocate to a specific
output are Direct costs (e.g. labour cost, material cost)
– Indirect costs are the costs that are difficult to allocate to a
specific out put(e.g. fixed costs such as rent; administration
costs, Security costs). Allocation of such costs are done through
a selected formula or method. E.g. Administration costs can be
allocated to cost units based on number of units sold; Overhead
cost can be used as a synonym to indirect costs.
– Standard costs are planned costs per unit based on direct and
indirect cost allocations. Standard cost is important when
comparing it with the actual cost. Also when estimating future
manufacturing costs.

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• Cash cost and book cost
– Costs that involve in cash outflow. However, some costs do not involve cash
outflows, and referred to as noncash costs or book costs. Depreciation is a
good example for a book costs. Only cash costs are considered in many
engineering economic analyses. Non cash costs are important when it comes
to tax purposes.
• Sunk cost
– Are the ones that occurred in the past and has no relevance to estimates of
future costs. Same as book costs this cost component are not considered in
economic analysis , but do so for tax purposes.
• Opportunity cost
– Forgone benefits of second best alternative when selecting the best
alternative
• Life cycle cost
– Summation of all costs related to a product or service during its life span.

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 Measures of economic worth
• Price demand and its elasticity
• Total revenue

• Example: plot total revenue vs demand

• Cost, volume (demand) and break even point

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Price per
unit (P)
# Demand for any product or
service will go down if price is
increased

# Some products reduction in

demand is more than
proportionate if substitutes for
that products exist

Demand
(D)

𝑷 = 𝑎 − 𝑏 𝑫; (𝒚 = 𝒄 + 𝒎𝒙 𝒕𝒚𝒑𝒆)

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 PED1 PED2 # A particular vegetable is more price elastic (PED =slope >1) , as
Price Units price units the consumer will start buying another vegetable that is not
75 1300 75 1300 subject to price increase
# However, reduction in units sold (or demand) is less responsive
100 1200 100 600 of all vegetables are subject to price increment; consumer doesn’t
33.33 -7.69 33.33 -53.85 have an option
slope -0.23 -1.62 # Also, PED < 1 (inelastic ) for products like Benz cars

% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑄𝑢𝑎𝑛𝑡𝑖𝑡𝑦 𝐷𝑒𝑚𝑎𝑛𝑑𝑒𝑑

𝑃𝑟𝑖𝑐𝑒 𝐸𝑙𝑎𝑠𝑡𝑖𝑐𝑖𝑡𝑦 𝑜𝑓 𝐷𝑒𝑚𝑎𝑛𝑑 (𝑃𝐸𝐷) =
% 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑃𝑟𝑖𝑐𝑒
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 How to increase Revenue (sales)?
• Increase in revenue will guarantee a profit or
in worst case will reduce the loss
• Increasing revenue depend on the price
elasticity of demand

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 PED1 PED2
Price Units price units
75 1300 75 1300
100 1200 100 600
slope -0.23 -1.62
PED 0.23 1.62
<1 >1
Price inelastic case Price elastic case

PED1 PED2
Price Units Revenue price units Revenue
75 1300 97500 75 1300 97500
100 1200 130000 100 600 60000

Revenue has increased Revenue has decreased

Therefore, for price inelastic products (e.g. Benz cars) the pricing strategy should
be increasing the price, as it will guarantee more revenue. Whereas, for price
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elastic products strategy should be reducing the price
 Total revenue vs demand
𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 = 𝑃𝑟𝑖𝑐𝑒 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡 × 𝑡𝑜𝑡𝑎𝑙 𝑢𝑛𝑖𝑡𝑠 𝑠𝑜𝑙𝑑
𝑇𝑅 = 𝑃 × 𝐷
𝐴𝑙𝑠𝑜, 𝑃 = 𝑎 − 𝑏 𝐷
∴ 𝑇𝑅 = (𝑎 − 𝑏 𝐷) × 𝐷

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 Total cost
• Total cost = TFC + TVC
TFC TVC

TC

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Total Revenue, total cost and profit
Total cost = CT

As per this number

of units sold or
demand needs to
be in between
𝐷1′ 𝑎𝑛𝑑 𝐷2′

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Optimal Demand when Demand is a function of price
A company produces an electronic timing switch that is used in consumer
and commercial products. The fixed cost (CF) 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). For this situation,
(a) Determine the optimal volume for this product and confirm that a profit
occurs (instead of loss) at this demand.
(b) Find the volumes at which breakeven occurs; that is, what is the range of
profitable demand? Solve by hand and by spreadsheet.

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Breakeven Point when price is independent of demand
An engineering consulting firm measures its output in a standard service hour
unit, which is a function of the personnel grade levels in the professional staff.
The variable cost (Cv) is $62 per standard service hour. The charge out rate [i.e.,
selling price (p)] is @85.56 per hour. The maximum output of the firm is 160,000
hours per year, and its fixed cost (CF) is $2,024,000 per year. For this firm,
(a) What is the breakeven point in standard service hours and in percentage of
total capacity?

(a) What is the percentage reduction in the breakeven point (sensitivity) if fixed
costs are reduced 10%; if variable cost per hour is reduced 10%; and if the
selling price per unit is increased by 10% ?

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 Cost driven design optimisation
The cost of operating a jet powered commercial airplane
varies as 3/2 of its velocity (i.e. 𝐶𝑜 = 𝑘𝑛𝑣 3/2 where n is the
trip length in miles, K is a constant of proportionality, and v is
velocity in miles per hour. It is known that at 400 miles per
hour, the average cost of operation is 300 USD per mile.
Company wants to minimise the cost of operation, but that
cost must be balanced against the cost of passenger time (Cc),
which has been set at 300,000 USD per hour.
(a) At what velocity should the trip be planned to minimise
the total cost, which is the sum of the cost of operating
and the cost of the passengers time?
(b) How do you know that your answer for the problem in
part (a) minimises the total cost

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