1. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics1 L:26 Project Cost Elements and Income Tax Rate to Be Used ECON 320 Engineering Economics Mahmut Ali GOKCE Industrial Systems Engineering Computer Sciences

2. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Chapter 9 – Chapter Opening Story Home Depot – 1,487 retail stores Plant to install self-service checkouts in about 300 high volume stores ($40 million) Use less number of cashiers, shoplifting, and improve customer satisfaction  How do you estimate these cost savings?

3. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Engineering Economic Decisions Evaluation of a Fixed Asset –Equipment –Buildings Valuation of Fixed Assets –Based on usable after-tax cash flows the asset produces

4. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics General Cost Terms Manufacturing Costs Direct materials Direct labor Mfg. Overhead Non-manufacturing Costs Overhead Marketing Administrative

5. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics 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  Matched against periods, they become expenses immediately Product costs:Those costs that are matched against revenues on a product basis.  Matched against products, become expenses when the product is sold

6. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Cost Classification for Predicting Cost Behavior Volume index Cost Behaviors Fixed costs Variable costs Mixed costs Average unit costs

7. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Volume Index Cost behavior how a cost item will react/respond to changes in the level of business activity. Def: The unit measure used to define “volume”  Might be based on production inputs or outputs Examples:  Automobile – “miles” driven  Generating plant – “kWh” produced  Stamping machine – “parts” stamped Fixed and variable cost is two most common cost behavior patterns

8. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Fixed Costs Def: The costs of providing a company’s basic operating capacity Cost behavior: Remain constant over the relevant range

9. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Variable Costs Def: Costs that vary depending on the level of production or sales  Depends on volume Cost behavior: Increase or decrease proportionally according to the level of volume Marginal contribution= unit sales price-unit variable cost

10. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Mixed Costs Partly fixed, partly variable costs  Depreciation of a car, Car depreciates as time goes by, no matter how much you drive. Car depreciates more if you drive it more.  Electric bill: Electric usage for lighting heating: independent of production volume More production, more machines work, use more electricity

11. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics 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.

12. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics 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

13. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics What Income Tax Rate Should be Used in Project Analysis? Regular Business Project Revenues Expenses $200,000 $130,000 $40,000 $20,000 Taxable Income Income Taxes $70,000 $12,500 $20,000 ?

14. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics Incremental Income Tax Rate Before Undertaking Project After Undertaking Project The Effect of Project Gross revenue$200,000$240,000$40,000 Expenses130,000150,00020,000 Taxable income$70,000$90,000$20,000 Income taxes$12,500$18,850$6,350 Average tax rate 17.86% 20.94% 31.75% This is the tax rate that should be used in project in project evaluation.

15. www.izmirekonomi.edu.tr (c) 2001 Contemporary Engineering Economics BeforeAfterIncremental Taxable income$70,000$90,000$20,000 Income taxes12,50018,8506,350 Average tax rate17.86%20.94% Incremental tax rate31.75% $0 $20,000$40,000$60,000$80,000$100,000 Regular income from operation $20,000 incremental taxable income due to undertaking project Marginal tax rate 15%25%34% $5,000 at 25% $15,000 at 34% 0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%