Contemporary Engineering Economics
Contemporary Engineering Economics, 5th edition, © 2010
General Cost Terms
 Manufacturing Costs
 Direct Raw Materials
 Direct Labor
 Manufacturing Overhead
 Nonmanufacturing Costs
 Overhead
 Marketing
 Administrative Functions
Contemporary Engineering Economics, 5th edition, © 2010
Various Types of Manufacturing Costs
Contemporary Engineering Economics, 5th edition, © 2010
Classifying Costs for Financial Statements
 Matching Concept: The costs
incurred to generate particular
revenue should be recognized as
expenses in the same period that
the revenue is recognized.
 Period Costs: Those costs that are
matched against revenues on a
time period basis
 Product Costs: Those costs that are
matched against revenues on a
product basis.
Contemporary Engineering Economics, 5th edition, © 2010
Example
 Period Costs:
 General and administrative




expenses
Marketing expenses
Insurance premiums
Income taxes
Nonmanufacturing costs
 Product Costs:
 Direct material costs
 Direct labor costs
 Manufacturing overhead
Contemporary Engineering Economics, 5th edition, © 2010
How the Period Costs and Product Costs
Flow Through Financial Statement
Contemporary Engineering Economics, 5th edition, © 2010
Cost Flows and Classifications in a
Manufacturing Company
Contemporary Engineering Economics, 5th edition, © 2010
Example 8.1 Classifying Costs for Uptown Ice
Cream Shop
 Breakdown of Unit Cost items
 Product Costs:
 Period Costs:
Contemporary Engineering Economics, 5th edition, © 2010
Cost Classification for Predicting Cost
Behaviors
 Volume index
 Cost Behaviors patterns
Fixed costs
Variable costs
Mixed costs
 Average unit costs
Contemporary Engineering Economics, 5th edition, © 2010
Volume Index
 Def: The unit measure used to
define “volume” that influence
the amount of cost
 Examples:
 “Tons” of coal processed
 Automobile – “miles” driven
 Generating plant – “kWh”
produced
 Stamping machine – “parts”
stamped
 Assembly Plant – “units”
assembled
Contemporary Engineering Economics, 5th edition, © 2010
Fixed Costs
 Def: The costs of
providing a company’s
basic operating capacity
 Cost behavior: Remain
constant over the
relevant range
 Example: Insurance cost,
property tax, and license
fees
Contemporary Engineering Economics, 5th edition, © 2010
Variable Costs
 Def: Costs that vary
depending on the level of
production or sales
 Cost behaviors: Increase
or decrease
proportionally according
to the level of volume
 Example: Gasoline ,
material cost, wages,
payroll tax, sales taxes
Contemporary Engineering Economics, 5th edition, © 2010
Mixed Costs
 Def: Costs are fixed for a set
Depreciation Expenses ($)
level of production or
consumption, becoming
variable after the level
exceeded.
 Cost behavior: Increase or
decrease after maintaining a
fixed level of expense
 Example: depreciation, utilities
Mixed cost behavior
6000
5000
4000
3000
2000
1000
0
Contemporary Engineering Economics, 5th edition, © 2010
5
15
25
Miles Driven (Unit: 1,000)
Average Unit Cost
 Previous costs were in terms of
volume over given period. Average
cost is used to express activity cost
 Def: activity cost per unit basis
 Cost Behaviors in terms of unit cost:
 Fixed cost per unit varies with changes
in volume.
 Variable cost per unit of volume is a
constant.
 Mixed cost per unit of volume contains
both the constant and variable elements
Contemporary Engineering Economics, 5th edition, © 2010
Future Costs for Business Decisions
 Differential (Incremental)
cost
 Opportunity cost
 Sunk cost
 Marginal cost
Contemporary Engineering Economics, 5th edition, © 2010
Differential (Incremental) Costs
 Def: Costs that represent the differences in
total costs, which results from selecting one
alternative instead of other
 Cost behavior: Increase or decrease with the
overall change that a company experiences
by producing one additional unit of good
 Examples:
1.
2.
Operational cost (to add overtime
Saturday or second shift)
Make or buy decisions
Contemporary Engineering Economics, 5th edition, © 2010
Opportunity Costs
 Def: The potential benefit that is given up
as you seek an alternative course of
action
 Example:
 When you decide to pursue a college
degree, your opportunity cost would
include a 4-year’s potential earnings
foregone.
 Company using a machine that has been
already owned in a new project
Contemporary Engineering Economics, 5th edition, © 2010
Sunk Costs
 Def: Cost that has already been
incurred by past actions
 Economic Implications: Not
relevant to future decisions
 Example: $500 spent to replace
brakes last year—not relevant in
making a selling decision in the
future
Contemporary Engineering Economics, 5th edition, © 2010
Marginal Costs
 Def: Added costs that result from
increasing rates of outputs,
usually by single unit
 Example: Cost of electricity—
decreasing marginal rate
Contemporary Engineering Economics, 5th edition, © 2010
Illustration of Full Cost Concept
Direct
Material
Cost
+
=
Direct
Labor
Cost
Full
Production
Cost (or
Inventory
Cost)
Prime Cost
+
=
Overhead
Cost
+
Selling
Cost
+
General and
Administrative Cost
Contemporary Engineering Economics, 5th edition, © 2010
Full
Cost
Example 8.7
Marginal Analysis
 Financial Data:
Daily demand – 1,000
cases
 Fixed cost - $5,000 per
week
 Variable cost:


Weekdays - $7 per case
Sundays - $12 per case
Generic aspirin production:
Unit price - $10 per case
 Product Mix:
Marginal contribution for GA: $10 - $7 = $3 per case
 Marginal contribution for BA: $30 - $7 = $23 per case
 Schedule the product with the highest MC, i.e., Brandname Aspirin

 Marginal Analysis on Sunday
Operation
Marginal revenue - $10 per case
 Marginal cost - $12 per case
 Sunday operation not economical

 Brand-name aspirin
production:
 Weekly demand – 1,000
cases per week
Unit price - $30 per case
 Break-Even Volume:
 At Issue: (1) How to schedule
the product mix and (2) Is it
worth operating on Sundays?
Contemporary Engineering Economics, 5th edition, © 2010
Weekly Profits as a
Function of Time
 Total Revenue and Cost Functions:
o Schedule Brand-name aspirin first
o Schedule Generic aspirin for 5 days
o Do not schedule anything on Sundays
 Net Profit as a Function of production Volume
Contemporary Engineering Economics, 5th edition, © 2010
Contemporary Engineering Economics, 5th edition, © 2010
Calculation of Operating Income
 Operating revenue:
 The income earned by a business as a result of providing
products or services to customers
 Operating expenses:
 The expenses incurred to generate the revenues of the
specified operating period.
 Operating Income:
 The difference between the operating revenue and
operating expenses
Contemporary Engineering Economics, 5th edition, © 2010
Process of Creating a Master Production
Budget
Contemporary Engineering Economics, 5th edition, © 2010
Sales Budget for a Manufacturing Business
Total annual volume = 5,000 units
Unit sales price = $15
Contemporary Engineering Economics, 5th edition, © 2010
Preparing the Production Budget
Desired ending inventory units to carry: 20% of the budgeted units
Beginning inventory position: 100 units
Contemporary Engineering Economics, 5th edition, © 2010
Direct Materials Budget
 Year 2010 – Product X
Contemporary Engineering Economics, 5th edition, © 2010
Direct Labor Budget
Labor cost per unit = $3.00
Contemporary Engineering Economics, 5th edition, © 2010
Overhead Budget
Variable overhead rate = $1.50 per unit
Fixed overhead rate = $230 per quarter
Contemporary Engineering Economics, 5th edition, © 2010
Cost of Goods Sold Budget
Contemporary Engineering Economics, 5th edition, © 2010
Selling Expenses Budget
Variable commission rate = 5% of unit sales
Contemporary Engineering Economics, 5th edition, © 2010
Administrative Expenses Budget
Contemporary Engineering Economics, 5th edition, © 2010
The Budgeted Income Statement
Contemporary Engineering Economics, 5th edition, © 2010
Measures for Profitability
 Gross margin
Gross margin = Gross income/Net sales
= $31,580/$75,000 = 42.11%
 Operating margin
Operating margin = Operating income/Net sales
= $13,890/$75,000 = 18.52%
 Net profit margin
Net profit margin = Net income/Net sales
= $9,029/$75,000 = 12.04%
Contemporary Engineering Economics, 5th edition, © 2010
Contemporary Engineering Economics, 5th edition, © 2010