CHAPTER 2
COST CONCEPTS AND
DESIGN ECONOMICS
OBJECTIVES
• Describe basic cost terminology
• Describe design economics
Cash Flows
• A cash flow is a receipt or
payment of an amount of
money defined by 1) its
dollar value and 2) the time
of its occurrence
• Cash flow diagrams
represent costs and
revenues over time.
• Cost and Revenue estimation
for the future always involve
uncertainty.
$ value
0
0
1
2
3
4
3
time
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
Top-Down Estimate
• The first step in the determination of the
cash flows is the estimation of costs and
revenues.
• The top-down approach takes data from
similar projects and modifies them to
reflect the current project.
– Estimate your cost of a college degree: use the
cost of your brother’s degree three years ago
and adjust it for inflation. Add $5000 for the
cost of your participation in extra curricular
activities (your brother was a bookworm)
8
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
Bottom-Up Estimates
• The bottom-up approach is more
detailed, breaking down the project
in small manageable units and
estimating the cost of the parts first.
– Bottom-Up: Break down anticipated
expenses in categories: tuition and
fees, books and supplies, living
expenses, transportation and estimate
each as accurately as possible.
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CASH COST VERSUS BOOK COST
• A cash cost requires the cash transaction
of dollars "out of one person's pocket" into
"the pocket of someone else." When you
buy dinner for your friends or make your
monthly automobile payment you are
incurring a cash cost or cash flow. Cash
costs and cash flows are the basis for
engineering economic analysis.
CASH COST VERSUS BOOK COST
• Book cost or noncash cost is a payment
that does not involve cash transaction;
book costs represent the recovery of past
expenditures over a fixed period of time;
• Depreciation is the most common example
of book cost; depreciation is what is
charged for the use of assets, such as plant
and equipment; depreciation is not a cash
flow;
SUNK COST AND OPPORTUNITY
COST
• A sunk cost is money already spent as a
result of a past decision. Sunk costs should
be disregarded in our engineering
economic analysis because current
decisions cannot change the past.
SUNK COST AND OPPORTUNITY
COST
• For example, dollars spent last year to
purchase new production machinery is
money that is sunk: the money allocated to
purchase the production machinery has
already been spent-there is nothing that can
be done now to change that action.
SUNK COST AND OPPORTUNITY
COST
• Many times it is difficult not to be influenced by
sunk costs. Consider 100 shares of stock in XYZ,
Inc., purchased for $15 per share last year. The
share price has steadily declined over the past
12months to a price of $10 per share today.
Current decisions must focus on the $10 per
share that could be attained today (as well as
future price potential), not the $15 per share that
was paid last year. The $15 per share paid last
year is a sunk cost and has no influence on
present opportunities.
SUNK COST AND OPPORTUNITY
COST
• As another example, when Regina was a
sophomore, she purchased a newest-generation
laptop from the college bookstore for $2000. By
the time she graduated, the most anyone would
pay her for the computer was $400 because the
newest models were faster, cheaper and had more
capabilities. For Regina the original purchase
price was a sunk cost that has no influence on her
present opportunity to sell the laptop at its
current market value ($400).
SUNK COST AND OPPORTUNITY
COST
• An opportunity cost is associated with
using a resource in one activity instead of
another.
• Every time we use a business resource
(equipment, dollars,manpower, etc.) in one
activity, we give up the opportunity to use
the same resources at that time in some
other activity.
SUNK COST AND OPPORTUNITY COST
• Every day businesses use resources to accomplish various
tasks-forklifts are used to transport materials, engineers are
used to design products and processes, assembly lines are
used to make a product, and parking lots are used to provide
parking for employees' vehicles. Each of these resources costs
the company money to maintain for those intended purposes.
However, that cost is not just made up of the dollar cost, it also
includes the opportunity cost. Each resource that a firm owns
can feasibly be used in several alternative
ways. For instance, the assembly line could produce a different
product, and the parking lot could be rented out, used as a
building site, or converted into a small airstrip. Each of these
alternative uses would provide some benefit to the company.
SUNK COST AND OPPORTUNITY COST
• Your grandmother owns her home, but lives with
your parents. She rents her $185,000-house for
$400/month. Good idea or lost opportunity?
• An opportunity cost is the benefit that is forgone
by engaging a business resource in a chosen
activity instead of engaging that same resource in
the forgone activity.
SUNK COST AND OPPORTUNITY
COST
• Example, suppose that friends invite a college student to
travel through Europe over the summer break. In
considering the offer, the student might calculate all the
out-of-pocket cash costs that would be incurred.
Cost estimates might be made for items such as air
travel, lodging, meals, entertainment, and train passes.
Suppose this amounts to $3000 for a to-week period.
After checking his bank account, the student reports that
indeed he can afford the $3000 trip.
SUNK COST AND OPPORTUNITY
COST
• However, the true cost to the student
includes not only his outof-pocket cash costs but also his
opportunity cost. By taking the trip, the
student is giving up the opportunity to
earn $5000 as a summer intern at a local
business. The student's total cost will
comprise the $3000 cash cost as well as
the $5000 opportunity cost (wages
forgone)-the total cost to our traveler is
thus $8000.
LIFE-CYCLE COST
Life-cycle cost is the 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 need or
want ( the requirement ) and ends with
the retirement and disposal activities.
LIFE-CYCLE COST
• The products, goods, and services designed by
engineers all progress through a life cycle very much
like the human life cycle.
• People are conceived, go through a growth phase,
reach their peak during maturity, and then gradually
decline and expire.
• The same general pattern holds for products, goods,
and services. As with humans, the duration of the
different phases, the height of the peak at maturity, and
the time of the onset of decline and termination all vary
depending on the individual product, good, or service.
Figure 2-3 illustrates the typical phases that a product,
good or service progresses through over its life cycle.
LIFE-CYCLE COST
FIGURE 2-3 Typical life cycle for products, goods and
services.
LIFE-CYCLE COST
• Life-cycle costing refers to the concept of designing
products, goods, and services with a full and explicit
recognition of the associated costs over the various
phases of their life cycles.
• Two key concepts in life-cycle costing are that the later
design changes are made, the higher the costs, and that
decisions made early in the life cycle tend to "lock in"
costs that are incurred later.
• Figure 2-4 illustrates how costs are committed early in
the product life cycle-nearly 70-90% of all costs are set
during the design phases. At the same time, as the figure
shows, only 10-30% of cumulative life-cycle costs have
been spent.
LIFE-CYCLE COST
FIGURE 2-4 Cumulative life-cycle costs committed and dollars
spent.
LIFE-CYCLE COST
FIGURE 2-5 Life-cycle design change costs and ease of
change.
LIFE-CYCLE COST
• Figure 2-5 reinforces these concepts by
illustrating that downstream product changes' are
more costly and that upstream changes are
easier (and less costly) to make.
• When planners try to save money at an early
design stage, the result is often a poor design,
calling for change orders during construction and
prototype development. These changes, in turn,
are more costly than working out a better design
would have been.
LIFE-CYCLE COST
• From Figures2-4 and 2-5 we see that the time to consider
all life-cycle effects, and make design changes, is during
the needs and conceptual/preliminary design phasesbefore a lot of dollars are committed. Some of the life-cycle
effects that engineers should consider at design time
include product costs for liability, production, material,
testing and quality assurance, and maintenance and
warranty.
• Other life-cycle effects include product features based on
customer input and product disposal effects on the
environment. The key point is that engineers who design
products and the systems that produce them should
consider all life-cycle costs. . ..
CAPITAL AND INVESTMENT
• Investment Cost or capital investment is the
capital (money) required for most activities of the
acquisition phase;
• Working Capital refers to the funds required for
current assets needed for start-up and
subsequent support of operation activities;
• Operation and Maintenance Cost includes many
of the recurring annual expense items associated
with the operation phase of the life cycle;
• Disposal Cost includes non-recurring costs of
shutting down the operation;
FIXED, VARIABLE, AND INCREMENTAL
COSTS
• Fixed costs are those unaffected by
changes in activity level over a feasible
range of operations for the capacity or
capability available.
• Typical fixed costs include insurance and
taxes on facilities, general management and
administrative salaries, license fees, and
interest costs on borrowed capital.
• When large changes in usage of resources
occur, or when plant expansion or
shutdown is involved fixed costs will be
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 AND NONRECURRING COSTS
• Recurring costs are repetitive and occur
when a firm produces similar goods and
services on a continuing basis.
• Variable costs are recurring costs because
they repeat with each unit of output .
• A fixed cost that is paid on a repeatable
basis is also a recurring cost:
$
– Office space rental
RECURRING AND NONRECURRING COSTS
• Nonrecurring costs are those that are not
repetitive, even though the total
expenditure may be cumulative over a
relatively short period of time;
• Typically involve developing or
establishing a capability or capacity to
operate;
• Examples are purchase cost for real estate
upon which a plant will be built, and the
construction costs of the plant itself;
DIRECT, INDIRECT AND OVERHEAD COSTS
• Direct costs can be reasonably measured
and allocated to a specific output or work
activity -- labor and material directly
allocated with a product, service or
construction activity;
• Indirect costs are difficult to allocate to a
specific output or activity -- costs of
common tools, general supplies, and
equipment maintenance ;
DIRECT, INDIRECT AND OVERHEAD COSTS
• Overhead consists of plant operating costs
that are not direct labor or material costs
– indirect costs, overhead and burden are the
same;
• Prime Cost is a common method of
allocating overhead costs among products,
services and activities in proportion the
sum of direct labor and materials cost ;
STANDARD COSTS
• Representative costs per unit of output that
are established in advance of actual
production and service delivery;
Standard Cost Element
Direct Labor
+
Direct Material
+
Factory Overhead Costs
Sources of Data
Process routing sheets,
standard times, standard
labor rates;
Material quantities per
unit, standard unit
materials cost;
Total factory overhead
costs allocated based on
prime costs;
SOME STANDARD COST USES
• Estimating future manufacturing or service
delivery 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;
FIXED,VARIABLE AND INCREMENTAL
COSTS
• incremental cost is the additional cost that results
from increasing the output of a system by one (or
more) units.
• Incremental cost is often associated with “go / no
go” decisions that involve a limited change in
output or activity level.
EXAMPLE
• the incremental cost of driving an automobile
might be $0.27 / mile. This cost depends on:
– mileage driven;
– mileage expected to drive;
– age of car;
CONSUMER GOODS AND PRODUCER
GOODS AND SERVICES
• Consumer goods and services are those
that are directly used by people to satisfy
their wants;
• Producer goods and services are those
used in the production of consumer goods
and services: machine tools, factory
buildings, buses and farm machinery are
examples;
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
1.
2.
A company may choose to produce an item in house,
rather than purchase from a supplier at a price lower than
production costs 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
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.