1. COST CONCEPTS AND DESIGN ECONOMICS
CHAPTER 2
COST CONCEPTS AND DESIGN ECONOMICS

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

3. 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

4. COST ESTIMATION APPROACHES
Top-down Approach
Bottom-up Approach

5. 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

6. 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

7. 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

8. 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

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

10. 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 $

11. 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

12. 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’

13. 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

14. 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

15. 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

16. 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.

17. 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.

18. 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

19. 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

20. 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

21. 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)

22. 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

23. 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

24. 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

25. 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).

26. 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

27. 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)

28. 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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

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

36. 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

37. 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

38. 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

39. 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

40. 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

41. 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
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

42. 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 $ 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 $ per day. This estimate of actual cost savings per
day is less than the potential savings indicated by the cost accounting records
($ per day), and it would not exceed the $ 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

43. 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