Engineering Economy

MEC 2001
First Term 2022 -2023

Chapter #2:
Cost Concepts and Design Economics

Instructor:
Dr. Khaled Mohamed Soliman
Mechanical Engineering Department
Industrial Engineering Program
Faculty of Engineering
 Agenda
 Cost Terminology
 Cost-Driven Optimization
 Present Economy Studies
 Break-Even Points Analysis

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 The objective of this chapter is to
analyze short-term alternatives
when the time value of money is
not a factor.

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 Cost Terminology
 Fixed Costs (CF) 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.

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 Cost Terminology (Cont’d)
 Variable Costs (Cv) 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.

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 Cost Terminology (Cont’d)
 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;

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 Problem 2-2
Classify each of the following cost items as mostly
fixed or variable:
 Raw materials Administrative salaries
 Direct labor Payroll taxes
 Depreciation Utilities
 Clerical salaries Property taxes
 Sales commissions Insurance
 Rent Interest on borrowed
money

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 Solution

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 Problem 2-4
 A municipal solid-waste site for a city must be located at Site
A or Site B. After sorting, some of the solid refuse will be
transported to an electric power plant where it will be used
as fuel. Data for the hauling of refuse from each site to the
power plant are shown in the following table.

If the power plant will pay $8.00 per cubic yard of sorted solid
waste delivered to the plant, where should the solid-waste
site be located? Use the city’s viewpoint and assume that
200,000 cubic yards of refuse will be hauled to the plant for
one year only. One site must be selected.
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 Solution
Cost Site A Site B
Fixed $5,000 $100,000
(Rent)
Variable (4)(200,000)($1.50) = (3)(200,000)($1.50)
(Hauling) $1,200,000 = $900,000
Total $1,205,000 $1,000,000

Note that the revenue of $8.00/yd3 is independent of

the site selected. Thus, we can maximize profit by
minimizing total cost. The solid site waste site
should be located in Site B.

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 More ways to categorize 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 ;

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 STANDARD COSTS
• Representative costs per unit of output that are
established in advance of actual production and service
delivery;

Standard Cost Element Sources of Data

Direct Labor Process routing sheets,
standard times, standard
+ labor rates;
Direct Material Material quantities per
unit, standard unit
+ materials cost;
Factory Overhead Costs Total factory overhead
costs allocated based on
prime costs;

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 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;
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 We need to use common cost
terminology
 Cash cost is a cost that involves payment in
cash and results in cash flow;
 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;

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 Sunk Cost
 A 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;
 The concept of sunk cost is illustrated in
the next simple example.

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 Sunk Cost (Cont’d)
 Suppose that Joe College finds a motorcycle he likes and
pays $40 as a down payment, which will be applied to the
$1,300 purchase price, but which must be forfeited if he
decides not to take the cycle.
 Over the weekend, Joe finds another motorcycle he
considers equally desirable for a purchase price of
$1,230. For the purpose of deciding which cycle to
purchase, the $40 is a sunk cost and thus would not enter
 into the decision, except that it lowers the remaining cost
of the first cycle.
 The decision then is between paying an additional $1,260
($1,300 − $40) for the first motorcycle versus $1,230 for
the second motorcycle.
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 Opportunity Cost
 An opportunity cost is incurred because of the use of
limited resources, such that the opportunity to use
those resources to monetary advantage in an
alternative use is foregone.
 Thus, it is the cost of the best rejected (i.e., foregone)
opportunity and is often hidden or implied.
 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.
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 Engineers must consider cost in
the design of products, processes
and services.

 “ Cost-driven design optimization ” is

critical in today’s competitive business
environment.
 In our brief examination we examine
discrete and continuous problems that
consider a single primary cost driver.

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 Two main tasks are involved in
cost-driven design optimization.

1. Determine the optimal value for a certain

alternative’s design variable.
2. Select the best alternative, each with its
own unique value for the design
variable.

Cost models are developed around the

design variable, X.
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 “Present economy studies” can
ignore the time value of money.
 Alternatives are being compared over one year
or less.
 Rule 1:
 When revenues and other economic benefits
vary among alternatives, choose the
alternative that maximizes overall
profitability of defect-free output.
 Rule 2:
 When revenues and other economic benefits
are not present or are constant among
alternatives, choose the alternative that
minimizes total cost per defect-free unit.
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 Profit Function
 let p(D) be the total revenue (TR) obtained
from producing and selling D units of a good
at a unit price (p)
 Profit (P) = Total Revenue  Total Cost (CT)
 Profit = Total Revenue  [Fixed costs +
Variable costs]
P = (p*D) – [CF+ (cv*D)]

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 Total Costs

(D)

TR = p * D
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 Break-Even Point

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 Scenario 1
• Assume that price and demand are independent of each
other
• Price is constant

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 Example #2-5

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 Solution

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 Solution (Cont’d)

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 Solution (Cont’d)

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 Scenario 2
The demand for a
product or service is
directly related to its
price according to
p = a – bD
where p is price, D is
demand, and a and b are
constants that depend on
the particular product or
service.
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 Break-Even Points
Revenue & Cost Functions
$500

$400
Revenue
$300
(M's)

Cost
$200

$100

$0
0 400 800 1,200 1,600 2,000 2,400 2,800
q (K's)

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 Example #2-4

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 Solution

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 Solution (Cont’d)

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