Contemporary Engineering Economics Contemporary Engineering Economics, 5 th edition, © 2010

General Cost Terms Manufacturing Costs Direct Raw Materials Direct Labor Manufacturing Overhead Nonmanufacturing Costs Overhead Marketing Administrative Functions Contemporary Engineering Economics, 5 th edition, © 2010

Various Types of Manufacturing Costs Contemporary Engineering Economics, 5 th 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, 5 th 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, 5 th edition, © 2010

How the Period Costs and Product Costs Flow Through Financial Statement Contemporary Engineering Economics, 5 th edition, © 2010

Cost Flows and Classifications in a Manufacturing Company Contemporary Engineering Economics, 5 th edition, © 2010

Example 8.1 Classifying Costs for Uptown Ice Cream Shop Breakdown of Unit Cost items Product Costs: Period Costs: Contemporary Engineering Economics, 5 th 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, 5 th 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, 5 th 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, 5 th 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, 5 th edition, © 2010

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 Example: depreciation, utilities Contemporary Engineering Economics, 5 th edition, © Mixed cost behavior Miles Driven (Unit: 1,000) Depreciation Expenses ($)

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, 5 th edition, © 2010

Future Costs for Business Decisions Differential (Incremental) cost Opportunity cost Sunk cost Marginal cost Contemporary Engineering Economics, 5 th 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. Operational cost (to add overtime Saturday or second shift) 2. Make or buy decisions Contemporary Engineering Economics, 5 th 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, 5 th 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, 5 th 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, 5 th edition, © 2010

Illustration of Full Cost Concept Contemporary Engineering Economics, 5 th edition, © 2010

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  Brand-name aspirin production:  Weekly demand – 1,000 cases per week  Unit price - $30 per case  At Issue: (1) How to schedule the product mix and (2) Is it worth operating on Sundays? Contemporary Engineering Economics, 5 th edition, © 2010 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., Brand- name Aspirin Marginal Analysis on Sunday Operation Marginal revenue - $10 per case Marginal cost - $12 per case Sunday operation not economical Break-Even Volume :

Weekly Profits as a Function of Time  Total Revenue and Cost Functions:  Net Profit as a Function of production Volume Contemporary Engineering Economics, 5 th edition, © 2010 o Schedule Brand-name aspirin first o Schedule Generic aspirin for 5 days o Do not schedule anything on Sundays

Contemporary Engineering Economics, 5 th 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, 5 th edition, © 2010

Process of Creating a Master Production Budget Contemporary Engineering Economics, 5 th edition, © 2010

Sales Budget for a Manufacturing Business Contemporary Engineering Economics, 5 th edition, © 2010 Total annual volume = 5,000 units Unit sales price = $15

Preparing the Production Budget Contemporary Engineering Economics, 5 th edition, © 2010 Desired ending inventory units to carry: 20% of the budgeted units Beginning inventory position: 100 units

Direct Materials Budget Contemporary Engineering Economics, 5 th edition, © 2010 Year 2010 – Product X

Direct Labor Budget Contemporary Engineering Economics, 5 th edition, © 2010 Labor cost per unit = $3.00

Overhead Budget Contemporary Engineering Economics, 5 th edition, © 2010 Variable overhead rate = $1.50 per unit Fixed overhead rate = $230 per quarter

Cost of Goods Sold Budget Contemporary Engineering Economics, 5 th edition, © 2010

Selling Expenses Budget Contemporary Engineering Economics, 5 th edition, © 2010 Variable commission rate = 5% of unit sales

Administrative Expenses Budget Contemporary Engineering Economics, 5 th edition, © 2010

The Budgeted Income Statement Contemporary Engineering Economics, 5 th 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, 5 th edition, © 2010