Cost Concepts and Design

Economics
Cost Terminology
What is Cost?
In business and accounting, cost is the monetary
value spent by a company to produce a product.
It does not include profit mark-up
Fixed, Variable, and Incremental Costs
• Fixed costs:
Are those costs that don’t change based on production levels.
- Unaffected by changes in activity level over a feasible range
of operations for the capacity or capability available.

Examples:
- Insurance and Taxes on facilities
- administrative salaries
- License fees
- Interest cost on borrowed capital
- Rent .
Fixed, Variable, and Incremental Costs
• Variable costs:
Are costs that vary with output.
- Change according to the quantity of a good or service being
produced.
Examples:
- Costs of material and labor used in a product
or service
- Sales tax
- Hauling
- Packaging
- Fuel costs
Fixed, Variable, and Incremental Costs
• Incremental costs:
Is the additional cost (or revenue) 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.
Fixed and Variable Costs
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. The
contractor estimates that it will cost $2.75 per cubic
yard mile (yd3-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):
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 $12 per cubic yard
delivered to the job location?
 Direct, Indirect, and Standard Costs
• Direct costs:
Are costs that can be reasonably measured and allocated to a
specific output or work activity.

Examples:
Labor and material costs directly associated with a product,
service, or construction activity
 Direct, Indirect, and Standard Costs
• Indirect costs:
Are costs that are difficult to allocate to a specific
output or work activity.

Examples:
- Costs of common tools
- General supplies
- Equipment maintenance
in a plant
 Direct, Indirect, and Standard Costs
• Standard costs:
Are planned costs per unit of output.

- Standard costs play an important role in cost control

and other management functions
 Cash Cost versus Book Cost
• Cash Cost:
A cost that involves payment of cash (and results in a cash
flow)

• Book Cost:
a cost that does not involve a cash transaction but is reflected
in the accounting system.
(equipment, machines, Depreciation)
 Sunk Cost
• Is one that has occurred in the past and has no relevance to
estimates of future costs and revenues related to an
alternative course of action.
- Independent of future costs
- Incurred in past
- Cannot be recovered

Examples:
- Earnest money on a house
- Money spent on a passport
 Opportunity Cost
• Is the monetary advantage foregone due to limited
resources.
- The cost of the best rejected opportunity.

Example:
- Consider a student who could earn $20,000 for working
during a year, but chooses instead to go to school for a year
and spend $5,000 to do so.
The opportunity cost of going to school for that year is
$25,000: $5,000 cash outlay and $20,000 for income
foregone.
 Life-Cycle Cost
• It refers to a summation of all the costs related to a
product, structure, system, or service during its life span.
The General Economic
Environment
 Consumer and Producer Goods and
Services
• Consumer goods and services are those products or
services that are directly used by people to satisfy their
wants. Food, clothing, homes, cars, television sets, haircuts,
opera, and medical services are examples.
• Producer goods and services are used to produce consumer
goods and services or other producer goods. Machine
tools, factory buildings, buses, and farm machinery are
examples.
• Goods and services are produced and desired because
they have utility—the power to satisfy human wants
and needs. Thus, they may be used or consumed
directly, or they may be used to produce other goods or
services. Utility is most commonly measured in terms of
value, expressed in some medium of exchange as the
price that must be paid to obtain the particular item.
• Much of our business activity, including engineering,
focuses on increasing the utility (value) of materials and
products by changing their form or location.
 Necessities and Luxuries
Goods and services may be divided into two types:
necessities and luxuries.
Obviously, these terms are relative, because, for most
goods and services, what one person considers a necessity
may be considered a luxury by another.
 Price (P) – Demand (D) Relationship
• For all goods and services, there is a
relationship between the price that must be
paid and the quantity that will be demanded
or purchased.
• As the selling price
per unit (p) is
increased, there will
be less demand (D)
for the product, and
as the selling price is
decreased, the
demand will
increase.
• The relationship
between price and
demand can be
expressed as the
linear function General Price–Demand Relationship.
 p = a - bD
for 0 ≤ D ≤ a/b , a > 0, b > 0
where p is price, D is demand, and a and b are constants that
depend on the particular product or service.

Where a is the intercept on the price axis and −b is the slope.

Thus, b is the amount by which demand increases for each
unit decrease in p. Both a and b are constants.

It follows, of course, that

D = (a − p)/b (b≠ 0).
 Competition
• Perfect competition occurs in a situation in which any given
product is supplied by a large number of vendors and there is
no restriction on additional suppliers entering the market.
(never occur in actual practice)
However, with conditions of perfect competition assumed, it is
easier to formulate general economic laws.

• perfect monopoly exists when a unique product or service is

only available from a single supplier and that vendor can
prevent the entry of all others into the market.(rarely occur in
Practice)
 The Total Revenue (TR) Function
The total revenue, TR, that will result from a business venture
during a given period is the product of the selling price per unit,
p, and the number of units sold, D.
Thus, TR = price × demand = p × D
But, p = a - bD
TR = (a − bD)D = aD − bD2 for 0 ≤ D ≤a/b and a > 0, b > 0.
From calculus, the demand,   , that will produce maximum total
revenue can be obtained by solving
dTR/dD = a − 2bD = 0.
 = a/ 2b
Thus ; 
  
−
Maximum TR = a 
 = − =




Total Revenue Function as a Function of Demand

 Cost, Volume, and Breakeven Point
Relationships
• At any demand D;
Total Cost (CT) = Fixed Cost (CF) + Variable Cost (CV)
C T = CF + CV

Variable Cost (CV) = Variable cost per unit (cv) × Demand (D)
CV =cv × D

Total Cost : CT = CF + cv × D
Scenario 1: Demand is a Function of Price

Combined Cost and Revenue Functions, and Breakeven Points, as

Functions of Volume, and Their Effect on Typical Profit (Scenario 1)
• At breakeven point D′1, total revenue is equal to total
cost, and an increase in demand will result in a profit
for the operation.
• Then at optimal demand, D∗, profit is maximized
• At breakeven point D′2, total revenue and total cost
are again equal, but additional volume will result in
an operating loss instead of a profit.
At any volume (demand), D,
Profit (loss) = total revenue − total costs
= (aD − bD2) − (CF + cvD)
= −bD2 + (a − cv)D − CF
for 0 ≤ D ≤a/b and a > 0, b > 0.

In order for a profit to occur, two conditions must be met:

1. (a − cv) > 0; that is, the price per unit that will result in no
demand has to be greater than the variable cost per unit. (This
avoids negative demand.)
2. Total revenue (TR) must exceed total cost (CT) for the period
involved.
To find the maximum profit:

= −  − 2 = 0

 

= −2 ! 0


The optimal value of D that maximizes profit is:

∗
  
 
2
An economic breakeven point for an operation occurs when
total revenue equals total cost.
Then for total revenue and total cost, at any demand D,

Total revenue = total cost (breakeven point)

aD − bD2 = CF + cvD
−bD2 + (a − cv)D − CF = 0

The demand at breakeven

−  −  #  −   − 4 − −% '/
  &
" =
−2
 Example: 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), based on
Equation (p = a − bD). For this situation,
(a) determine the optimal volume for this product and
confirm that a profit occurs (instead of a loss) at this demand.
(b) find the volumes at which breakeven occurs; that is, what
is the range of profitable demand?
Scenario 2: Price and Demand are
Independent

Typical Breakeven Chart with Price ( p) a Constant

(Scenario 2)
Example: 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?
(b) 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%?