COST CONCEPTS AND DESIGN ECONOMICS Chapter # 2 Objectives Objectives of Chapter 2 are: Describe some of the basic cost c ost terminology and concepts encountered in the book Illustrate how they should be used in engineering economic analysis and decision making Following topics are discussed: Fixed, variable and incremental costs Recurring and nonrecurring costs Direct, indirect and overhead costs Standard costs Cash cost versus book cost Sunk and opportunity costs Life cycle and life cycle costs General economic environment Relationship between price and demand, total revenue function Break even point(s), maximizing profits, present economy studies s tudies Objectives Objectives of Chapter 2 are: Describe some of the basic cost c ost terminology and concepts encountered in the book Illustrate how they should be used in engineering economic analysis and decision making Following topics are discussed: Fixed, variable and incremental costs Recurring and nonrecurring costs Direct, indirect and overhead costs Standard costs Cash cost versus book cost Sunk and opportunity costs Life cycle and life cycle costs General economic environment Relationship between price and demand, total revenue function Break even point(s), maximizing profits, present economy studies s tudies Introduction Need balancing between technical and economical feasibility Engineering economy should be used to attain acceptable acceptab le balance Chapter # 2 integrates cost concepts, principles of engineering economy and design considerat consideration ion Cost Estimating The process by which the present and future cost consequences of engineering designs are forecast Most prospective characteristics Projects – relatively unique Based on past outcomes and adjust the data Involve personnel from several sectors Purposes 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 (for simplicity, price=cost + profit) Evaluate how much capital can be be justified for process changes or other improvements Establish benchmarks for productivity improvement programs Cost Estimating – Approaches Top-down Approach Uses historical data for current projects - costs, revenues, and other parameters Modifies original data for changes in inflation/deflation, activity level, weight, energy consumption, size, etc... Works well at earlier stages of the estimation Bottom-up Approach More detailed method of cost estimating Break down a project into small, manageable units and estimate costs and economic consequences Works best when details concerning desired output are defined and clarified Origins of Engineering Economy Fixed, Variable & Incremental Costs Fixed Cost Variable Costs Those unaffected by changes in activity level over a feasible range of operations for the capacity or capability available Those associated with an operation that vary in total with the quantity of output or other measures of activity level Incremental Costs or Incremental Revenue The additional cost or revenue that results from increasing the output of a system by one (or more) units Example 2-1 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. The contractor estimates that it will cost $1.15 per cubic yard per mile (yd/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 costs at each site are the same): Cost Factor Site A Site B Average hauling distance 6 miles 4.3 miles Monthly rental of site $1,000 $5,000 Cost to set up and remove equipment $15,000 $25,000 Hauling expense Flag person $1.15/yd3-mile $1.15/yd3-mile Not required $96/day 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 that the cost of the 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 per cubic yard delivered to the job location? Example 2-1 Select a site among A & B (tables) ? Requires 50,000 yd3 at job location 1.15/yd3-mile for asphalt mixing plant production costs at each site are the same 4 month ( 17 weeks x 5 days) Break even with paid $8.05 / yd 3 ? Cost Factor Site A Site B Average hauling distance 6 miles 4.3 miles Monthly rental of site $1,000 $5,000 Cost to set up and remove equipment $15,000 $25,000 Hauling expense $1.15/yd3 - mile $1.15/yd3 - mile Flag person Not required $96/day Example 2-1 Cost Fixed Rent X = $ 4,000 = $ 20,000 Setup/removal X = 15,000 = 25,000 Flag person X =0 Hauling Variable X Site A 6(50,000) ($1.15) Total: Site B = 45,000 5(17)($96) = 8,160 4.3(50,000)($1.15) = 247,250 $ 364,000 Select B : larger fixed cost + smaller variable cost Profit (break even) 4.3 ($1.15) = $4.945/ yd 3 Total Cost = Total Revenue fixed + variable = Revenue $53,160 + $4.945 X = $8.05 x $4.945 X = 17,121 yd 3 delivered = $300,410 Example 2-2 Problem : Cost for trips 4 students 400 miles driving x 2 ways Cost list (table) Cost Element Gasoline Oil and lubrication Tires Depreciation Insurance and taxes Repairs Garage Total Cost per mile $0.120 * 0.021 * 0.027 * 0.150 0.024 0.030 * 0.012 $0.384 Example 2-2 Solution 1 (Car owner) Solution 2 (Other students) Cost/mile = $ 0.384 (annual average 15,000 miles) 0.384 x 800 mile = $ 102.4 x 3 Cost/mile = $ 0.198 (Gasoline, Oil and lubrication, Tires, Repairs) 0.198 x 800 mile = $ 158.40 = $ 52.80 x 3 Solution 3 (considering additional miles) 15,000 x $0.384 18,000 x $ ? $810 / 3,000 0.27 x 800 mile = $5760 = $6570 (given cost service) = $0.270 = $216.00 = $72.00 x 3 Recurring and Nonrecurring Costs Recurring costs repetitive and occur when a firm produces similar goods and services on a continuing basis variable costs – recurring fixed cost paid on a repeatable basis - recurring • ex: office rental Nonrecurring costs not repetitive, even though the total expenditure may be cumulative over a relatively short period of time ex: purchase cost for real estate, construction costs Direct, Indirect and Standard Costs Direct costs reasonably measured and allocated to a specific output or work activity labor and material directly allocated with a product, service or construction activity ex: material cost for a pair of scissors Indirect costs difficult to allocate to a specific output or activity costs allocated through a selected formula (such as, proportional to direct labor hours, direct labor cost, direct material cost, or others) • ex: costs of common tools, general supplies, and equipment maintenance indirect costs = overhead = burden • ex: electricity, general repairs, property taxes, supervision • administrative selling expenses – added to direct cost • allocate overheads costs among product/services/activates Direct, Indirect and Standard Costs Standard Costs representative costs/unit established in advance developed from anticipated direct labor hours, materials, overhead categories with their established costs per unit Important role in cost control and other management some typical uses are the following: • • • • 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 Standard Costs Standard Cost Element Sources of Data for Standard Costs Direct Labor Process Routing sheets, standard times, standard labor rates + Direct Material Material quantities per unit, standard unit material costs + Factory Overheads = Standard cost (per unit) Total factory overhead costs allocated based on prime costs (direct labor plus direct material costs) Cash Cost versus Book Cost Cash cost a cost that involves payment in cash and results in cash flow future transaction (potential) incurred for the alternatives Book cost costs that do not involve cash payment but rather represent the recovery of past expenditures over a fixed period of time such as depreciation depreciation • • is not a cash flow only affects income taxes, cash flow EE needs to consider only cash flows or potential cash flows Sunk Cost Sunk cost one that has occurred in the past has no relevance to estimates of future costs and revenues related to an alternative course of action nonrefundable cash outlays ex motorcycle 1 - $40 (down payment) + $1260 = $1300 motorcycle 2 - $40 (down payment) + $1230 = $1270 emotionally difficult to do Example 2-3 Original Purchasing Price - $50,000 Current Book value - $ 20,000 Current Market price - $5,000 Sunk Cost • • View 1 - $50,000 : sunk cost for replacement View 2 - $15,000 : difference between real value and book value Opportunity Cost Opportunity cost the cost of the best rejected (i.e., foregone) opportunity Incurred because of the limited resources Ex: Student for working - $20,000 for going to school - $5,000 (expenses) opportunity cost - $25,000 ($5,000 cash outlay and $20,000 for income foregone) Example 2-4 Purchasing - $50,000 Book value - $ 20,000 Market price - $5,000 By keeping the equipment, the firm is giving up the opportunity to obtain $5,000 from its disposal $5,000 immediate selling price is really the investment cost of not replacing the equipment and is based on the opportunity cost concept Life – Cycle Cost 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 ends with the retirement and disposal activities functional or economic basis (shorter than functional) ex: old boiler may be able to produce the steam required, but not economically enough for the intended use Figure 2-1 Phases of the Life Cycle and Their Relative Cost Figure 2-2 Costs of Design Changes Are Significant Life – Cycle Cost Investment cost Working capital funds required for current assets for start up & operational activities materials in inventory for delivery spare parts, tools, personnel for maintenance cash for employee salaries, other expenses Operation & Maintenance cost capital required in acquisition phase a single or a series of expenditure capital investment recurring annual expense items people, machine, materials, energy & information Disposal cost nonrecurring cost be offset by remaining market value Example 2-5 Consider the situation where equipment and related support for a new computer aided design / computer-aided manufacturing work station are being acquired for the engineering department that you work in. The applicable cost elements and estimated expenditures are as follows: Cost Element Install a leased telephone line for communication Lease CAD/CAM software (includes installation & debugging) Purchase hardware (CAD/CAM workstation) Cost $1,100/month 500/month 20,000 Purchase 9600-baud modem 2,500 Purchase a high-speed printer 1,500 Purchase four-color plotter Shipping costs Initial training (in house) to gain proficiency with CAD/CAM software What is the investment of this CAD/CAM software? 10,000 500 The General Economy Environment Consumer / Producer Goods and Services Consumer goods/services products or services, directly used by people ex: food, clothing, homes, cars, TV sets, opera, haircuts, and medical services etc Producers must be aware of the changing wants of the people Producer goods/services products or services to produce consumer goods and services or other producer goods ex: machine tools, factory buildings, buses, etc Measures of Economic Worth Goods/services are produced and desired because directly or indirectly they have UTILITY. Utility measure of the value which consumers of a product or service place on that product or service power to satisfy human wants and needs commonly measured in terms of value, expressed in some medium of exchange as the price Necessities, Luxuries, and Price Demand Necessities and luxuries – Two types of goods and services These terms are relative one person considers Goods/Services a necessity, another considers it a luxury Price - equals some constant value minus some multiple of the quantity demanded p = a – bD for 0 ≤ D ≤ a/b, and a>0, b>o D = (a – p) / b (b≠0) Lower price - Large demand (2-1) (2-2) p p = a – bD : e c i r P Units of Demand : D Price-Demand Relationship for Luxuries & Necessities Extent to which price changes influence demand varies according to the elasticity of demand Demand is elastic when a decrease in selling price results in considerable increase in sales If a change in selling price produces little or no effect on demand, the demand is said to be inelastic Competition Competition exists in general economic situations Perfect competition Monopoly product is supplied by a large number of vendors no restriction on additional suppliers complete freedom on the part of both buyer and seller may never occur in actual practice. opposite from perfect competition products/service is only available from a single supplier prevent the entry of all others perfect monopolies rarely occur in practice Oligopoly when there are so few suppliers of a product or service that action by one will almost inevitably result in similar action by the other Total Revenue Function Total Revenue TR = price × demand = p(D) TR = (a – bD) D = aD – bD2 for 0 ≤ D ≤ a/b, and a>0, b>0 Maximum revenue For MR, dTR/dD = a –2bD = 0 D’ = a / 2b MR = aD–bD2 = a(a/2b) – b(a/2b) 2 = a2/2b - a2/4b = a2/4b (2-5) (2-6) (2-3) (2-4) Cost, Volume, and Breakeven Point Relationships CT = CF + CV CV = c v . D Scenario 1: p = a - b D , Larger Volume – lower price Profit is maximized where total revenue exceeds total cost by greatest amount Cost, Volume, and Breakeven Point Relationships Max Profit D* occurs where Profit (total revenue - total costs) is maximized PR = (aD-bD2) - (CF+CvD) = -bD2+(a-Cv)D - CF (2-9) (a - cv) > 0; that is price per unit that will result in no demand has to be greater than variable cost per unit Total revenue (TR) must exceed total cost CT for the period involved dPR/dD = a – cv – 2bD = 0 D* = [ a - Cv ]/2b (2-10) Cost, Volume, and Breakeven Point Relationships Max Profit D* occurs where Profit (total revenue - total costs) is maximized PR = (aD-bD2) - (CF+CvD) = -bD2+(a-Cv)D - CF (2-9) dPR/dD=0 D* = [ a - Cv ]/2b (2-10) Breakeven points (D’1, D’2) occur when TR = CT or Profit = 0 -bD2 +(a-Cv)D - CF = 0 D’ = [-(a - Cv) +/- {(a-Cv)2 - 4(-b)(-CF)}1/2 ]/2(-b) Example 2 – 6 A company producing electronic timing switch. Per month: Cf = $73; 000 and Cv = $83 Moreover, p = $180 – 0.02(D) Determine: (a) (b) Optimal volume and confirm that a profit occurs at this demand Volume at which breakeven occurs Example 2 – 6 A company produces an electronic 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 per unit is p - $180 - 0.02(D), based on Equation (21). For this situation: a) Determine the optimal volume for this product and confirm that a profit occurs (instead of a loss) at this demand, and b) Find the volumes at which breakeven occurs; that is, what is the domain of profitable demand? Example 2-6 Example 2-6 Cost, Volume, and Breakeven Point Relationships Example 2-7 Example 2-7 Example 2-7 Thus, the breakeven point is more sensitive to a reduction in variable cost per hour than to the same percentage reduction in the fixed cost Furthermore, notice that the breakeven point in this example is highly sensitive to the selling price per unit, p. Present Economy Studies Present Economy Study One year or less period Rule 1 When the influence of time on money is not significant consideration, cost analysis When revenues and other economic benefits are present and vary among alternatives, choose the alternative that maximizes overall profitability based on the number of defect-free units of a product or service produced Rule 2 When revenues and other economic benefits are not present or are constant among all alternatives, consider only the costs and select the alternative that minimizes total cost per defect-free unit of product or service output Present Economy Studies Total Cost in Material Selection Material selection cannot be based solely on costs of materials. Change in materials frequently affect design, processing, and shipping costs. Alternative Machine Speeds Machine speeds result in different rates of product output and frequencies of machine downtime. Such situations lead to present economy studies Present Economy Studies Make vs. Purchase (Outsourcing) Studies Short run production, one year or less Choose “Make” rather than “Purchase” at a price lower than production costs if: • • Decision, based on • • Costs (direct, indirect, overhead) are incurred regardless of whether the item is purchased Incremental production cost is less than purchase price incremental costs opportunity costs of resources For long run, capital investments in additional manufacturing plant may be feasible alternatives Example : Total Cost in Material Selection A good example of this situation is illustrated by a part for which annual demand is 100,000 units. The part is produced on a high-speed turret lathe, using 1112 screw-machine steel costing $0.30 per pound. A study was conducted to determine whether it might be cheaper to use brass screw stock, costing $1.40 per pound. Because the weight of steel required per piece was 0.0353 pounds and that of brass was 0.0384 pounds, the material cost per piece was $0.0106 for steel and $0.0538 for brass. However, when the manufacturing engineering department was consulted, it was found that, although 57.1 defect-free parts per hour were being produced by using steel, the output would be 102.9 defect- free parts per hour if brass were used. Which material should be used for this part? Example : Solution The machine attendant was paid $7.50 per hour, and the variable (i.e., traceable) overhead costs for the turret lathe were estimated to be $10.00 per hour. Thus, the total-cost comparison for the two materials is as follows: 1112 Steel Material Labor Overhead Total cost per piece Brass $0.30 x 0.0353 = $0.0106 $1.40 x 0.0384 $7.50/57.1 = 0.1313 $7.50/102.9 = 0.0729 $10.00/57.1 = 0.1751 $10.00/102.9 = 0.0972 $0.4484 = $0.0538 $0.2968 Saving per piece by use of brass = $0.3179 - $0.2239 = $0.0931 Because a large number of parts are made each year, the saving of $93.10 per thousand was a substantial amount. It is also clear that costs other than the cost of material are of basic importance in the economy study Example Later history of same product illustrates that shipping costs also must often be considered in selecting between materials. It was found desirable to supply domestic / foreign assembly plants of company by using air freight for shipping. This led to a study of the possible use of a heat-treated Al alloy. This material cost $0.85/pound and the cost of a heat treating each part, at an outside plant, was $0.018. Production studies indicated that Al alloy could be machined at the same speeds as brass stock. Specific gravities of brass and Al alloy are 8.7 and 2.75 respectively. Brass (lb) Aluminum Alloy (lb) Raw Material 0.0384 (0.0384)(2.75/8.8) = 0.01213 Finished Part 0.0150 (0.0150)(2.75/8.8) = 0.00474 Consequently, comparative costs, including shipping at $3.00/lb of finished part is: Brass (lb) Aluminum Alloy (lb) Material $1.40 x 0.0384 = $0.0538 $0.85 x 0.01213 = $0.0103 Labor $7.50 / 102.90 = $0.0729 $7.50 / 102.90 = $0.0729 Heat treatment Overhead Shipping - = $0.0180 $10 / 102.90 = $0.0972 $10 / 102.90 = $0.0972 $3.00 x 0.0150 = $0.0450 $3.00 x 0.00474 = $0.0142 Example : Alternative Machine Speeds A simple example of alternative machine speeds involves the planing of lumber. Lumber put through the planer increases in value by $0.10 per board foot. When the planer is operated at a cutting speed of 5,000 feet per minute, the blades have to be sharpened after 2 hours of operation, and the lumber can be planed at the rate of 1,000 board-feet per hour. When the machine is operated at 6,000 feet per minute, the blades have to be sharpened after 1-1/2 hours of operation, and the rate of planing is 1,200 board-feet per hour. Each time the blades are changed, the machine has to be shut down for 15 minutes. The blades, unsharpened, cost $50 per set and can be sharpened 10 times before having to be discarded. Sharpening costs $10 per occurrence. The crew that operates the planer changes and resets the blades. At what speed should the planer be operated? Example : Solution Because the labor cost for the crew would be the same for either speed of operation and because there was no discernible difference in wear upon the planer, these factors did not have to be included in the study. In problems of this type, the operating time plus the delay time due to the necessity for tool changes constitute a cycle time that determines the output from the machine . The time required for a complete cycle determines the number of cycles that can be accomplished in a period of available time (e.g., one day), and a certain portion of each complete cycle is productive. The actual productive time will be the product of the productive time per cycle and the number of cycles per day Example : Solution At 5,000 feet per minute Cycle time = 2 hours + 0.25 hour = 2.25 hours Cycles per day = 8 ÷ 2.25 = 3.555 Value added by planing = 3.555 x 2 x 1,000 x $0.10 = Cost of resharpening blades = 3.555 x $10 = $35.55 Cost of blades = 3.555 x $50/10 = 17.78 Total cost Net increase in value (profit) per day At 6,000 feet per minute Cycle time = 1.5 hours + 0.25 hour = 1.75 hours Cycles per day = 8 ÷ 1.75 = 4.57 Value added by planing = 4.57 x 1.5 x 1,200 x $0.10 = Cost of resharpening blades = 4.57 x $10 = $45.70 Cost of blades = 4.57 x $50/10 = 22.85 Total cost Net increase in value (profit) per day (cycles/day)(hours/cycle)(board feet/hour)(dollar value/board-foot) = dollars/day $711.00 -53.33 $657.67 $822.00 -68.55 $754.05 Example 2-8 : Make vs Purchase Studies A manufacturing plant consists of three departments: A, B, and C. Department A occupies 100 square meters in one corner of the plant. Product X is one of several products being produced in Department A. The daily production of Product X is 576 pieces. The cost accounting records show the following average daily production costs for Product X: Direct labor (1 operator working 4 hours per day at $22.50/hr, $120.00 including fringe benefits, plus a part-time foreman at $30 per day) 86.40 Direct material Overhead (at $0.82 per square meter of floor area) Total cost per day = 82.00 $288.40 The department foreman has recently learned about an outside company that sells Product X at $0.35 per piece. Accordingly, the foreman figured a cost per day of $0.35(576) = $201.60, resulting in a daily savings of $288.40-$201.60 = $86.80. Therefore, a proposal was submitted to the plant manager for shutting down the production line of Product X and buying it from the outside company Example 2-8 However, after examining each component separately, the plant manager decided not to accept the foreman's proposal based on the unit cost of Product X: 1. Direct labor: Because the foreman was supervising the manufacture of other products in Department A in addition to Product X, the only possible savings in labor would occur if the operator working 4 hours per day on Product X were not reassigned after this line is shut down. That is, a maximum savings of $90.00 per day would result 2. Materials: The maximum savings on direct material will be $86.40. However, this figure could be lower if some of the material for Product X is obtained from scrap of another product 3. Overhead: Because other products are made in Department A, no reduction in total floor space requirements will probably occur. Therefore, no reduction in overhead costs will result from discontinuing Product X. It has been estimated that there will be daily savings in the variable overhead costs traceable to Product X of about $3.00 due to a reduction in power costs and in insurance premiums