CHAPTER 2

COST CONCEPTS AND

DESIGN ECONOMICS
 COST ESTIMATING
Used to describe the process by
which the present and future cost
consequences of engineering
designs are forecast
 COST ESTIMATING USED TO
• Provide information used in setting a selling
price for quoting, bidding, or evaluating
contracts
• Determine whether a proposed product can be
made and distributed at a profit (EG: price =
cost + profit)
• Evaluate how much capital can be justified for
process changes or other improvements
• Establish benchmarks for productivity
improvement programs
COST ESTIMATING APPROACHES

• Top-down Approach
• Bottom-up Approach
 TOP-DOWN APPROACH
• Uses historical data from similar
engineering projects
• Used to estimate costs, revenues, and
other parameters for current project
• Modifies original data for changes in
inflation / deflation, activity level, weight,
energy consumption, size, etc…
• Best use is early in estimating process
 BOTTOM-UP APPROACH
• More detailed cost-estimating method
• Attempts to break down project into small,
manageable units and estimate costs, etc….
• Smaller unit costs added together with other
types of costs to obtain overall cost estimate
• Works best when detail concerning desired
output defined and clarified
 CASH
CASH COST
COST VERSUS
VERSUS BOOK
BOOK COST
COST
• Cash
Cash cost
cost is
is aa cost
cost that
that involves
involves payment
payment
in
in cash
cash and
and results
results inin cash
cash flow;
flow;
• Book
Book cost
cost or
or noncash
noncash cost cost is
is aa payment
payment
that
that does
does not
not involve
involve cash
cash transaction;
transaction;
book
book costs
costs represent
represent the the recovery
recovery of of past
past
expenditures
expenditures overover aa fixed
fixed period
period of of time;
time;
• Depreciatio
Depreciationn isis the
the most
most common
common example
example
of
of book
book cost;
cost; depreciation
depreciation is is what
what isis
charged
charged for
for the
the use
use of
of assets,
assets, such
such as as plant
plant
and
and equipment;
equipment; depreciation
depreciation is is not
not aa cash
cash
flow;
flow;
 SUNK
SUNK COST
COST AND
AND OPPORTUNITY
OPPORTUNITY
COST
COST
• A
A sunk
sunk cost
cost is is one
one that
that has
has occurred
occurred inin the
the
past
past and
and has
has no no relevance
relevance toto estimates
estimates of of
future
future costs
costs andand revenues
revenues related
related to
to an
an
alternative
alternative course
course of of action;
action;
• An
An opportunity
opportunity costcost is
is the
the cost
cost of
of the
the best
best
rejected
rejected (( i.e.,
i.e., foregone
foregone )) opportunity
opportunity andand is
is
hidden
hidden or
or implied;
implied;
 LIFE-CYCLE
LIFE-CYCLE COST
COST
Life-cycle
Life-cycle cost
cost is
is the
the summation
summation of of all
all
costs,
costs, both
both recurring
recurring and
and
nonrecurring,
nonrecurring, related
related toto aa product,
product,
structure,
structure, system,
system, or or service
service during
during its
its
life
life span.
span.
Life
Life cycle
cycle begins
begins with
with the
the identification
identification
of
of the
the economic
economic needneed oror want
want (( the
the
requirement
requirement )) and
and ends
ends with
with the
the
retirement
retirement and
and disposal
disposal activities.
activities.
 CAPITAL
CAPITAL AND
AND INVESTMENT
INVESTMENT
•• Investment
Investment Cost
Cost or
or capital
capital investment
investment is is the
the
capital
capital (money)
(money) required
required for
for most
most activities
activities of
of the
the
acquisition
acquisition phase;
phase;
•• Working
Working Capital
Capital refers
refers to
to the
the funds
funds required
required for
for
current
current assets
assets needed
needed for
for start-up
start-up and
and
subsequent
subsequent support
support of
of operation
operation activities;
activities;
•• Operation
Operation and
and Maintenance
Maintenance CostCost includes
includes many
many
of
of the
the recurring
recurring annual
annual expense
expense items
items associated
associated
with
with the
the operation
operation phase
phase ofof the
the life
life cycle;
cycle;
•• Disposal
Disposal Cost
Cost includes
includes non-recurring
non-recurring costscosts ofof
shutting
shutting down
down the
the operation;
operation;
 FIXED, VARIABLE, AND INCREMENTAL
COSTS
•• Fixed
Fixed costs
costs are
are those
those unaffected
unaffected byby changes
changes in in
activity
activity level
level over
over aa feasible
feasible range
range of
of operations
operations
for
for the
the capacity
capacity oror capability
capability available.
available.
•• Typical
Typical fixed
fixed costs
costs include
include insurance
insurance and
and taxes
taxes
on
on facilities,
facilities, general
general management
management and and
administrative
administrative salaries,
salaries, license
license fees,
fees, and
and interest
interest
costs
costs on
on borrowed
borrowed capital.
capital.
•• When
When large
large changes
changes in in usage
usage of
of resources
resources occur,
occur,
or
or when
when plant
plant expansion
expansion or or shutdown
shutdown isis involved
involved
fixed
fixed costs
costs will
will be
be affected.
affected.
 FIXED, VARIABLE AND INCREMENTAL
COSTS
• Variable costs are those associated with an
operation that vary in total with the quantity
of output or other measures of activity
level.
• Example of variable costs include : costs of
material and labor used in a product or
service, because they vary in total with the
number of output units -- even though
costs per unit remain the same.
RECURRING
RECURRING AND
AND NONRECURRING
NONRECURRING COSTS
COSTS

• Recurring
Recurring costs
costs are
are repetitive
repetitive and
and occur
occur
when
when aa firm
firm produces
produces similar
similar goods
goods and
and
services
services onon aa continuing
continuing basis.
basis.
• Variable
Variable costs
costs are
are recurring
recurring costs
costs because
because
they
they repeat
repeat with
with each
each unit
unit of
of output
output ..
• A
A fixed
fixed cost
cost that
that is
is paid
paid on
on aa repeatable
repeatable
basis
basis is
is also
also aa recurring
recurring cost:
cost:
– Office
Office space
space rental
rental $
 RECURRING
RECURRING AND
AND NONRECURRING
NONRECURRING COSTS
COSTS
• Nonrecurring
Nonrecurring costs
costs are
are those
those that
that are
are not
not
repetitive,
repetitive, even
even though
though the
the total
total
expenditure
expenditure maymay bebe cumulative
cumulative overover aa
relatively
relatively short
short period
period of
of time;
time;
• Typically
Typically involve
involve developing
developing or or
establishing
establishing aa capability
capability or
or capacity
capacity to to
operate;
operate;
• Examples
Examples are are purchase
purchase cost
cost for
for real
real estate
estate
upon
upon which
which aa plant
plant will
will be
be built,
built, and
and the
the
construction
construction costs
costs of
of the
the plant
plant itself;
itself;
DIRECT,
DIRECT, INDIRECT
INDIRECT AND
AND OVERHEAD
OVERHEAD COSTS
COSTS

• Direct
Direct costs
costs can
can bebe reasonably
reasonably measured
measured
and
and allocated
allocated to to aa specific
specific output
output oror work
work
activity
activity --
-- labor
labor and
and material
material directly
directly
allocated
allocated with
with aa product,
product, service
service or or
construction
construction activity;
activity;
• Indirect
Indirect costs
costs are
are difficult
difficult to
to allocate
allocate to
to aa
specific
specific output
output or or activity
activity --
-- costs
costs of
of
common
common tools,
tools, general
general supplies,
supplies, andand
equipment
equipment maintenance
maintenance ;;
DIRECT,
DIRECT, INDIRECT
INDIRECT AND
AND OVERHEAD
OVERHEAD COSTS
COSTS

• Overhead
Overhead consists
consists ofof plant
plant operating
operating costs
costs
that
that are
are not
not direct
direct labor
labor or
or material
material costs
costs
–– indirect
indirect costs,
costs, overhead
overhead and
and burden
burden are
are the
the
same;
same;
• Prime
Prime Cost
Cost is
is aa common
common method
method ofof
allocating
allocating overhead
overhead costs
costs among
among
products,
products, services
services and
and activities
activities in
in
proportion
proportion the
the sum
sum of
of direct
direct labor
labor and
and
materials
materials cost
cost ;;
 STANDARD
STANDARD COSTS
COSTS
• Representative
Representative costs
costs per
per unit
unit of
of output
output that
that
are
are established
established in
in advance
advance of
of actual
actual
production
production and
and service
service delivery;
delivery;
Standard
Standard Cost
Cost Element
Element Sources
Sources ofof Data
Data
Direct
Direct Labor
Labor Process
Process routing
routing sheets,
sheets, ++standard
standard
times,
times, standard
standard labor
labor rates;
rates;
Direct
Direct Material
Material Material
Material quantities
quantities per
per ++ unit,
unit,
standard
standard unit
unit materials
materials cost;
cost;
Factory
Factory Overhead
Overhead Costs
Costs Total
Total factory
factory overhead
overhead
costs
costs allocated
allocated based
based on
on prime
prime costs;
costs;
 SOME
SOME STANDARD
STANDARD COST
COST USES
USES
• Estimating
Estimating future
future manufacturing
manufacturing oror service
service
delivery
delivery costs;
costs;
• Measuring
Measuring operating
operating performance
performance byby
comparing
comparing actual
actual cost
cost per
per unit
unit with
with the
the
standard
standard unit
unit cost;
cost;
• Preparing
Preparing bids
bids on
on products
products or
or services
services
requested
requested byby customers;
customers;
• Establishing
Establishing the
the value
value of
of work-in-process
work-in-process
and
and finished
finished inventories;
inventories;
 FIXED,VARIABLE AND INCREMENTAL
COSTS
•• incremental
incremental cost
cost isis the
the additional
additional cost
cost that
that results
results
from
from increasing
increasing thethe output
output of
of aa system
system byby one
one (or
(or
more)
more) units.
units.
•• Incremental
Incremental cost
cost isis often
often associated
associated with
with “go
“go // no
no
go”
go” decisions
decisions that
that involve
involve aa limited
limited change
change in in
output
output oror activity
activity level.
level.
EXAMPLE
EXAMPLE
•• the
the incremental
incremental costcost ofof driving
driving anan automobile
automobile
might
might bebe $0.27
$0.27 // mile.
mile. This
This cost
cost depends
depends on:
on:
–– mileage
mileage driven;
driven;
–– mileage
mileage expected
expected to to drive;
drive;
–– age
age of
of car;
car;
 CONSUMER
CONSUMER GOODS
GOODS AND
AND PRODUCER
PRODUCER
GOODS
GOODS AND
AND SERVICES
SERVICES
• Consumer
Consumer goodsgoods and
and services
services are
are those
those
that
that are
are directly
directly used
used by
by people
people to
to satisfy
satisfy
their
their wants;
wants;
• Producer
Producer goods
goods and
and services
services are
are those
those
used
used inin the
the production
production ofof consumer
consumer goods
goods
and
and services:
services: machine
machine tools,
tools, factory
factory
buildings,
buildings, buses
buses and
and farm
farm machinery
machinery areare
examples;
examples;
 UTILITY
UTILITY AND
AND DEMAND
DEMAND

• Utility
Utility is
is aa measure
measure of of the
the value
value which
which
consumers
consumers of of aa product
product oror service
service
place
place onon that
that product
product or or service;
service;
• Demand
Demand is is aa reflection
reflection ofof this
this measure
measure
of
of value,
value, and
and is is represented
represented byby price
price
per
per quantity
quantity of of output;
output;
PRICE

QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD

QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD
a = Y-axis (quantity) intercept,
(price at 0 amount demanded);
b = slope of the demand function;

QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD
a = Y-axis (quantity) intercept,
(price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b

QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD
a = Y-axis (quantity) intercept,
(price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
PRICE QUANTITY ( OUTPUT )

Total Revenue = p x D
= (a – bD) x D

QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD
a = Y-axis (quantity) intercept,
(price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
PRICE QUANTITY ( OUTPUT )

Total Revenue = p x D
= (a – bD) x D
=aD – bD2
QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD
a = Y-axis (quantity) intercept,
(price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
PRICE QUANTITY ( OUTPUT )
MR = dTR / dD = a –2bD = 0

Total Revenue = p x D
= (a – bD) x D
=aD – bD2
QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD
a = Y-axis (quantity) intercept,
(price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
PRICE QUANTITY ( OUTPUT )
MR=0 MR = dTR / dD = a –2bD = 0

Total Revenue = p x D
= (a – bD) x D
=aD – bD2
QUANTITY ( OUTPUT )
PRICE Price equals some
a constant value minus some multiple
of the quantity demanded:
p=a-bD
a = Y-axis (quantity) intercept,
(price at 0 amount demanded);
b = slope of the demand function;
D = (a – p) / b
PRICE QUANTITY ( OUTPUT )
MR=0 MR = dTR / dD = a –2bD = 0

Total Revenue = p x D
TR = Max = (a – bD) x D
=aD – bD2
QUANTITY ( OUTPUT )
 Marginal

Cost / Revenue
( Incremental) Cost
Profit is maximum where
Total Revenue exceeds
Total Cost by greatest amount

Maximum Quantity ( Output )

Profit Marginal Demand
Revenue
Ct
Cost / Revenue

Profit Total Revenue

Cf
Quantity ( Output )
D’1 D* D’2 Demand
D’1 and D’2 are breakeven points
 PROFIT MAXIMIZATION
D*
• Occurs where total revenue exceeds
total cost by the greatest amount;
• Occurs where marginal cost =
marginal revenue;
• Occurs where dTR/dD = d Ct /dD;
• D* = [ a - Cv ] / 2b
 BREAKEVEN POINT
D’1 and D’2
• Occurs where TR = Ct
• ( aD - D2 ) / b = Cf + (Cv ) D
• - D2 / b + [ (a / b) - Cv ] D - Cf
• Using the quadratic formula: D’ =
- [ ( a / b ) - Cv ] + { [ (a / b ) - Cv ] 2 - ( 4 / b ) ( - Cf ) }1/2
------------------------------------------------------------------------
2/b
 COST-DRIVEN DESIGN OPTIMIZATION

Must maintain a life-cycle design perspective

Ensures engineers consider:
• Initial investment costs
• Operation and maintenance expenses
• Other annual expenses in later years
• Environmental and social consequences
over design life
 DESIGN FOR THE ENVIRONMENT
(DFE)
This green-engineering approach
has the following goals:
• Prevention of waste
• Improved materials selection
• Reuse and recycling of resources
COST-DRIVEN DESIGN OPTIMIZATION
PROBLEM TASKS
1. Determine optimal value for
certain alternative’s design
variable
2. Select the best alternative,
each with its own unique value
for the design variable
 COST-DRIVEN DESIGN OPTIMIZATION
PROBLEM COST TYPES
1. Fixed cost(s)
2. Cost(s) that vary directly with the design variable
3. Cost(s) that vary indirectly with the design variable
Simplified Format of Cost Model With One Design Variable

Cost = aX + (b / X) + k
a is a parameter that represents directly varying cost(s)
b is a parameter that represents indirectly varying cost(s)
k is a parameter that represents the faced cost(s)
X represents the design variable in question
(In a particular problem, the parameters a,b and k may actually represent
the sum of a group of costs in that category, and the design variable
may be raised to some power for either directly or indirectly varying
costs.)
GENERAL APPROACH FOR OPTIMIZING
A DESIGN WITH RESPECT TO COST
1. Identify primary cost-driving design variable
2. Write an expression for the cost model in terms
of the design variable
3. Set first derivative of cost model with respect to
continuous design variable equal to 0. (For
discrete design variables, compute cost model
for each discrete value over selected range).
4. Solve equation in step 3 for optimum value of
continuous design variables
5. For continuous design variables, use the second
derivative of the cost model with respect to the
design variable to determine whether optimum
corresponds to global maximum or minimum.
PRESENT ECONOMY STUDIES
When alternatives for accomplishing a task are
compared for one year or less (I.e., influence of
time on money is irrelevant)
Rules for Selecting Preferred Alternative
Rule 1 – When revenues and other economic
benefits are present and vary among alternatives,
choose alternative that maximizes overall
profitability based on the number of defect-free
units of output
Rule 2 – When revenues and economic benefits are
not present or are constant among alternatives,
consider only costs and select alternative that
minimizes total cost per defect-free output
PRESENT ECONOMY STUDIES
Total Cost in Material Selection
In many cases, selection of among materials
cannot be based solely on costs of materials.
Frequently, change in materials affect design,
processing, and shipping costs.
Alternative Machine Speeds
Machines can frequently be operated at different
speeds, resulting in different rates of product
output. However, this usually results in different
frequencies of machine downtime. Such
situations lead to present economy studies to
determine preferred operating speed.
 PRESENT ECONOMY STUDIES
Make Versus Purchase (Outsourcing) Studies
A company may choose to produce an item in house,
rather than purchase from a supplier at a price lower
than production costs if:
1. direct, indirect or overhead costs are incurred regardless
of whether the item is purchased from an outside
supplier, and
2. 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
 PRESENT ECONOMY STUDIES
Make Versus Purchase (Outsourcing) Studies
• Opportunity costs may become significant
when in-house manufacture of an item
causes other production opportunities to be
foregone (E.G., insufficient capacity)
• In the long run, capital investments in
additional manufacturing plant and capacity
are often feasible alternatives to
outsourcing.