COST CONCEPTS AND DESIGN ECONOMICS CHAPTER 2 COST CONCEPTS AND DESIGN ECONOMICS

COST ESTIMATION Cost Estimation is the process by which present and future cost of engineering designs/operations/products are predicted

COST ESTIMATION IS USED TO.. Why do we do cost estimation?? COST ESTIMATION IS USED TO.. Provide information to set a selling price for quoting, bidding, or evaluating contracts Determine whether a proposed product can be made and distributed at a profit (EG: price = cost + profit) Evaluate how much capital can be used for process changes or other improvements Establish benchmarks for productivity improvement programs

COST ESTIMATION APPROACHES Top-down Approach Bottom-up Approach

TOP-DOWN APPROACH Uses historical data from similar engineering projects Used to estimate costs, revenues, and other parameters for current projects Modifies original data for changes in inflation / deflation, activity level, weight, energy consumption, size, etc… Best when used early in the estimating process

BOTTOM-UP APPROACH More detailed cost-estimating method Breaks down project into small, manageable units to estimate the costs, etc Smaller unit costs added together with other types of costs to obtain overall cost estimate Works best when details concerning desired output are defined and clarified

FIXED COST Fixed costs are the costs that remain constant over a specific range of operating conditions. They are unaffected by changes in the activity level Typical fixed costs include rent, insurance and taxes on facilities, general management and administrative salaries, license fees, and interest costs on borrowed capital Fixed costs will be affected when there are large changes in the usage of resources, or when there is plant expansion or shutdown involved

VARIABLE COSTS Variable costs are those 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 with the number of output units -- even though the cost per unit remain the same

INCREMENTAL COST Incremental cost is the additional cost that results from increasing the output of a system by one (or more) units

RECURRING COSTS Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis. Variable costs are recurring costs because they repeat with each unit of output A fixed cost that is paid on a repeatable basis is also a recurring cost, for example office space rental $

NON-RECURRING COSTS Non-recurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time Typically involve developing or establishing a capability or capacity to operate Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself

DIRECT, INDIRECT COSTS Direct costs are costs that relate directly to a specific output or work activity. For example, labor and material directly allocated with a product or service Indirect costs are difficult to allocate to a specific output or activity. They include costs of common tools, general supplies, and equipment maintenance. Also known as ‘overhead’

STANDARD COST Standard cost is the cost per unit of output that are established in advance of actual production and service delivery, for a certain level of production They are developed from anticipated direct labor hours, materials, and overhead

STANDARD COST 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 Overhead Costs Total factory overhead costs

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-progess (WIP) and finished inventories

CASH COST, DEPRECIATION Cash cost is a cost that involves payment in cash or equivalent at the point of sale. Cash cost results in cash flow Depreciation is a reduction in the value of an asset with the passage of time, due in particular to wear and tear. All fixed assets are expected to be less efficient as time goes on.  Depreciation is not a cash flow.

SUNK COST A sunk cost occurs in the past and has no relevance to estimates of future costs and revenues. It is usually disregarded in an engineering economic analysis Joe pays $40 as a down payment for a motorcycle, which will be applied to the $1,300 purchase price, but must be forfeited if he decides not to take the motorcycle. Over the weekend, Joe finds another motorcycle he likes, which costs $1,230. For the purpose of deciding which motorcycle to buy, the $40 is a sunk cost and thus would not enter into the decision, except that it lowers the remaining cost of the first motorcycle. The decision then is between paying an additional $1,260 ($1,300 − $40) for the first motorcycle versus $1,230 for the second motorcycle.

Opportunity Cost An opportunity cost is the cost related to a missed opportunity. It is 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

PHASES OF A PRODUCT/SYSTEM A product generally has 2 phases – acquisition phase and operation phase Acquisition phase – identification of economic need, conceptual design, prototyping, detailed design, production planning, resource acquisition Operation phase – production, operation, customer use, retirement, disposal

LIFE CYCLE Life cycle – cradle to grave considerations - Life cycle costing - to make the interrelated effects of costs over the total life span for a product explicit. An objective of the design process is to minimize the life-cycle cost—while meeting other performance requirements—by making the right trade-offs between prospective costs during the acquisition phase and those during the operation phase

LIFE-CYCLE COSTING Life cycle costing begins in the acquisition phase (the identification of the economic need or want) and ends with the retirement and the disposal of the product (including its disposal activities)

LIFE-CYCLE COSTING Life-cycle cost is the summation of all costs - both recurring and non-recurring - related to a product, structure, system, or service during its life span Put it another way, it is the total cost of owning an asset over its entire life. It includes costs such as design and building costs, operating costs, associated financing costs, depreciation, and disposal costs. It also takes into account certain costs that are usually overlooked, such as environmental impact and social costs

CAPITAL AND INVESTMENT Investment Cost or capital investment is the capital (money) required for the activities carried out during the acquisition phase Working Capital refers to the funds required for current assets (working materials, tools, labor, etc) needed for start-up and subsequent support of operation activities Operation and Maintenance Cost (O & M) includes many of the recurring annual expense items associated with the operation phase of the life cycle (people, machine, material, energy, information) Disposal Cost includes non-recurring costs of shutting down the operation

CONSUMER GOODS AND SERVICES PRODUCER GOODS AND SERVICES Consumer goods and services are those that are directly used by people to satisfy their wants Producer goods and services are those used in the production of consumer goods and services - like machine tools, factory buildings, buses, farm machineries, etc

UTILITY AND DEMAND Utility is a measure of the value which consumers place on a product or service Demand is a reflection of this measure of value, and is represented by price per quantity of output Goods and services are produced because they have UTILITY (VALUE).

Much of our business activity, including engineering, focuses on increasing the utility (value) of materials and products by changing their form or location For example, Iron ore, worth only a few dollars per ton, significantly increases in value by being processed, combined with suitable alloying elements, and converted into razor blades Similarly, snow, worth almost nothing when high in distant mountains, becomes valuable when it is delivered in melted form several hundred miles away to deserts

Necessity vs Luxury Goods and services are divided into 2 types: necessities and luxuries. These terms are relative, because, for most goods and services, what one person considers a necessity may be considered a luxury by another (eg. A car may be a necessity in one location and a luxury in another location)

p = a − bD a PRICE Units of Demand (Price here is the independent variable even though it is depicted here on the y-axis (as is normal convention by economists) If the price is put high, there will be less demand for the goods. And vice-versa. A= intercept at y-axis, b = slope of the Demand function

PERFECT 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. Under such conditions, there is assurance of complete freedom on the part of both buyer and seller. Perfect competition may never occur in actual practice, because of a multitude of factors that impose some degree of limitation upon the actions of buyers or sellers, or both

Monopoly Monopoly is at the opposite of perfect competition. A 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. Under such conditions, the buyer is at the complete mercy of the supplier in terms of the availability and price of the product. Perfect monopolies rarely occur in practice, because (1) few products are so unique that substitutes cannot be used satisfactorily, and (2) governmental regulations prohibit monopolies where necessary

Total Revenue Total revenue, TR, is the product of the selling price per unit, p, and the number of units sold, D TR = price × Demand = p · D

Break-even Point The break-even level or break-even point (BEP) is the sales amount—in either unit or revenue terms—that is required to cover total costs (both fixed and variable) Profit at break-even is zero Break-even is only possible the price per unit product is higher than its variable costs per unit. If so, then each unit of the product sold will generate some “contribution” toward covering fixed costs

Break-even Point Market competition often creates pressure to lower the breakeven point of an operation The lower the breakeven point, the less likely that a loss will occur during market fluctuations. Also, if the selling price remains constant (or increases), a larger profit will be achieved at any level of operation above the reduced breakeven point

COST-DRIVEN DESIGN OPTIMIZATION Must maintain a life-cycle design perspective Ensures engineers consider: Initial investment costs Operation and maintenance expenses Other annual expenses in later years Environmental and social consequences over design life

DESIGN FOR THE ENVIRONMENT (DFE) This green-engineering approach has the following goals: Prevention of waste Improved materials selection Reuse and recycling of resources

PRESENT ECONOMY STUDIES When alternatives for accomplishing a task are compared for one year or less (I.e., influence of time on money is irrelevant), the economic analysis done to select the best alternative is called ‘present economy studies’ Rules for Selecting Preferred Alternative Rule 1 – When revenues and other economic benefits are present and vary among alternatives, choose alternative that maximizes overall profitability based on the number of defect-free units of output Rule 2 – When revenues and economic benefits are not present or are constant among alternatives, consider only costs and select alternative that minimizes total cost per defect-free output

PRESENT ECONOMY STUDIES Total Cost in Material Selection In many cases, selection of among materials cannot be based solely on costs of materials. Frequently, change in materials affect design, processing, and shipping costs Alternative Machine Speeds Machines can frequently be operated at different speeds, resulting in different rates of product output. However, this usually results in different frequencies of machine downtime. Such situations lead to present economy studies to determine preferred operating speed

PRESENT ECONOMY STUDIES Make Versus Purchase (Outsourcing) Studies A company may choose to produce an item in house, rather than purchase from a supplier if: Direct, indirect or overhead costs are already incurred regardless of whether the item is purchased from an outside supplier The incremental cost of producing the item in the short run is less than the supplier’s price

PRESENT ECONOMY STUDIES ‘Make Versus Purchase’ (Outsourcing) Studies Opportunity costs may become significant when in-house manufacture of an item causes other production opportunities to be foregone Generally, in the long run, capital investments in additional manufacturing plant and capacity are often feasible alternatives to outsourcing

GROUP ASSIGNMENT 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 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: Please hand in next week

Direct labor (1 operator working 4 hours per day on Product X only at RM22.50/hr PLUS one part time foreman who oversees all operations in Dept A at $30 per day) --- RM120.00 Direct material – RM 86.40 Overhead (at RM 0.82 per square meter of floor area) RM 82.00 TOTAL COST PER DAY = RM 288.40 An outside company sells Product X at RM 0.35 per piece. Some calculations were made, showing that if Product X was bought and not made, there would be a daily savings of RM 86.80.

Where does the suggested RM 86.80 daily savings come from? 2. Given that the daily savings in the variable overhead costs traceable to Product X is RM3.00 (due to a reduction in power costs and in insurance premiums), should Department A be closed, and Product X is bought from the outside company? Why? 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. If the manufacture of Product X is discontinued, the firm will save at most $90.00 in direct labor, $86.40 in direct materials, and $3.00 in variable overhead costs, which totals $179.40 per day. This estimate of actual cost savings per day is less than the potential savings indicated by the cost accounting records ($288.40 per day), and it would not exceed the $201.60 to be paid to the outside company if Product X is purchased. For this reason, the plant manager used Rule 2 and rejected the proposal of the foreman and continued the manufacture of Product X. In conclusion, Example 2-12 shows how an erroneous decision might be made by using the unit cost of Product X from the cost accounting records without detailed analysis. The fixed cost portion of Product X’s unit cost, which is present even if the manufacture of Product X is discontinued, was not properly accounted for in the original analysis by the foreman Please hand in next week

To make or to buy? Continue to make Buy Cost of operator RM90.00 RM0 Cost of foreman RM30.00 Cost of direct materials RM86.40** Cost of overhead RM82.00 RM79.00 Cost of buying ready-made Product X RM201.60 AMOUNT RM288.40 RM310.60