1. Classification of Costs
Lecture No. 29
Chapter 8
Contemporary Engineering Economics
Copyright © 2006
Contemporary Engineering Economics, 4th edition, © 2007

2. Chapter Opening Story – High Hopes for Plastic Beer Bottles
What is the least expensive way to make a 0.5L PET barrier beer bottle?
Types of Production Method
5-layer
3-layer
Internal coating
External coating
Capital investment (20,000 bottles/hr)
Direct Mfg Cost (per 1,000 units)
$10.8M
$59.35
$9.9M
$66.57
$9.2M
$46.90
$7.5M
$55.34
Comments
Need a bottle that provides shelf life of over 120 days with less than 15% loss of CO2 and admittance of no more than 1 ppm of oxygen
Contemporary Engineering Economics, 4th edition, © 2007

3. Contemporary Engineering Economics, 4th edition, © 2007
General Cost Terms
Manufacturing Costs
Direct Raw Materials
Direct Labor
Manufacturing Overhead
Nonmanufacturing Costs
Overhead
Marketing
Administrative Functions
Contemporary Engineering Economics, 4th edition, © 2007

4. Various Types of Manufacturing Costs
Figure: 08-01
Contemporary Engineering Economics, 4th edition, © 2007

5. 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, 4th edition, © 2007

6. Contemporary Engineering Economics, 4th edition, © 2007
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, 4th edition, © 2007

7. Contemporary Engineering Economics, 4th edition, © 2007
How the Period Costs and Product Costs Flow Through Financial Statement
Figure: 08-02
Contemporary Engineering Economics, 4th edition, © 2007

8. Cost Flows and Classifications in a Manufacturing Company
Figure: 08-03
Contemporary Engineering Economics, 4th edition, © 2007

9. Example 8.1 Classifying Costs for Uptown Ice Cream Shop
Unit Price of an Ice Cream
Ice cream (cream, sugar, milk, and milk solids)
$0.65
Cone
0.05
Product Cost
Rent
0.61
Wages
0.25
Payroll taxes
0.25
Sales taxes
0.23
Business taxes
0.08
Debt service
0.23
Period Cost
Supplies
0.09
Utilities
0.08
Other (insurance, advertising,professional fees)
0.05
Profit
0.13
$2.50
Contemporary Engineering Economics, 4th edition, © 2007

10. Cost Classification for Predicting Cost Behavior
Volume index
Cost Behaviors
Fixed costs
Variable costs
Mixed costs
Average unit costs
Contemporary Engineering Economics, 4th edition, © 2007

11. Contemporary Engineering Economics, 4th edition, © 2007
Volume Index
Def: The unit measure used to define “volume”
Examples:
Automobile – “miles” driven
Generating plant – “kWh” produced
Stamping machine – “parts” stamped
Contemporary Engineering Economics, 4th edition, © 2007

12. Contemporary Engineering Economics, 4th edition, © 2007
Fixed Costs
Def: The costs of providing a company’s basic operating capacity
Cost behavior: Remain constant over the relevant range
Contemporary Engineering Economics, 4th edition, © 2007

13. Contemporary Engineering Economics, 4th edition, © 2007
Variable Costs
Def: Costs that vary depending on the level of production or sales
Cost behavior: Increase or decrease proportionally according to the level of volume
Contemporary Engineering Economics, 4th edition, © 2007

14. Contemporary Engineering Economics, 4th edition, © 2007
Mixed Costs
Def: Costs are fixed for a set level of production or consumption, becoming variable after the level exceeded.
Cost behavior: Increase or decrease after maintaining a fixed level of expense
Mixed cost behavior
6000
5000
4000
Depreciation Expenses ($)
3000
2000
1000 5 15 25
Miles Driven (Unit: 1,000)
Contemporary Engineering Economics, 4th edition, © 2007

15. Contemporary Engineering Economics, 4th edition, © 2007
Average Unit Cost
Def: activity cost per unit basis
Cost Behaviors:
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, 4th edition, © 2007

16. Contemporary Engineering Economics, 4th edition, © 2007
Practice Problem
You have 3000 units to produce.
Total labor cost = $20,000
Total material cost = $25,000
Total overhead cost = $15,000
Total fixed cost = $40,000
What is the average cost per unit?
Average cost = ($100,000)/3,000 = $33.33/unit
Contemporary Engineering Economics, 4th edition, © 2007

17. Future Costs for Business Decisions
Differential (Incremental) cost
Opportunity cost
Sunk cost
Marginal cost
Contemporary Engineering Economics, 4th edition, © 2007

18. 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
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19. Contemporary Engineering Economics, 4th edition, © 2007
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.
Contemporary Engineering Economics, 4th edition, © 2007

20. Contemporary Engineering Economics, 4th edition, © 2007
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
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21. Contemporary Engineering Economics, 4th edition, © 2007
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, 4th edition, © 2007