Chapter 2 FUNDAMENTAL COST CONCEPTS ENGINEERING ECONOMICS (BPK 30902) Chapter 2 FUNDAMENTAL COST CONCEPTS ZUIKARNAIN DAUD

Contents Introduction Cost Terminology Fixed Cost, Variable Costs and Total Costs Recurring and Non-recurring Cost Direct, Indirect and Standard Costs Cash Cost versus Book Cost Sunk Cost Opportunity Cost Life-Cycle Cost

Introduction Cost terminology and concepts (the meaning and use of various cost terms and concepts) are important in engineering economy (EE) to be understood in order to communicate effectively with order engineering and management personnel The use of present economy studies in engineering decision making can provide satisfactory results and save considerable analysis effort by considering the various monetary consequences that occur in short time period

Cost Terminology A variety of costs that to be considered in EE analysis Costs differ in frequency of accurrence, relative magnitude and degree of impact by defining a number of cost categories and illustrate how they should be treated

Fixed Cost, Variable Costs & Total Costs Unaffected by changes in activity level feasible range in operation E.g. Insurance, general management & admintrative salaries etc

Fixed Cost, Variable Costs & Total Costs Those associated with operation that vary in total with quantity of output or other measure of activity level E.g. Cost s of material & labor used in a product or service

Fixed Cost, Variable Costs & Total Costs Sum of fixed costs & variable cost

Fixed Cost, Variable Costs & Total Costs Exercise A group of EE study team is making analysis in a decision to produce a new product in two alternative site. Details are as follows: Site A Site B Variable Cost (RM per unit) 1.20 0.90 Fixed Cost (RM per month) 5,000 7,500 Production Capacity (unit per month) 10,000 15,000

Fixed Cost, Variable Costs & Total Costs Solution: The most economic total cost is RM1.40 per unit for site B due to the higher capacity of production of 15,000 unit per month. If the production is limited to 10,000 units per month, the total cost for Site B per unit is still lower at RM1.65 only compare to site A. However total cost needed for site B is RM21,000 per month compare to site A of RM17,000 per month only. Site A Site B Variable Cost ( RM per month 12,000 13,500 Fixed Cost (RM per month) 5,000 7,500 Total Costs (RM per month) 17,000 21,000 Total Cost (per unit) 1.70 1.40 Total Costs at 10,000 unit output 16,500

Recurring and Nonrecurring Cost Annual expenses items for direct & indirect cost associated with five primary resources E.g. people, machines, materials, energy & information - major part expenses Non-recurring Cost Expenses for shutting down operation & retirement & disposal of assests E.g. Personnal, materials, transportation etc

Direct, Indirect and Standard Costs Direct costs Costs that can be reasonably measured and allocated to a specific output or work activity E.g. Labour & material costs directly associated with product, service or construction activity

Direct, Indirect and Standard Costs Costs that are difficult to attribute or allocate to a specific output or work activity E.g. Overhead include electricity, general repairs, supervision etc

Direct, Indirect and Standard Costs Planned costs per unit of output that are establised in advance of actual production or sevice delivery Developed from anticipated direct labour hours, materials & overhead categories (level of porduction)

Direct, Indirect and Standard Costs Plays an important role & other management fuctions as Estimating future manufacturing costs Measuring operating performace by comparing actual cost per unit with standard unit cost Preparing bid on product or service requested by customers Establishing the value of work in process & finised inventories

Cash Cost versus Book Cost A cost that involves payment of cash Estimated from the perspective established for the analysis & are the future expenses incurred for the alternatives being analyzed In EE analysis , only those costs that are cash flows or potential cash flows to be considered

Cash Cost versus Book Cost Book cost (noncash cost) A cost that does not involves a cash transaction and its relected in the accounting system Represent the recovery of past expenditures over a fixed period of time E.g. Depreciation (not a cash flows) charged on assets such as machines & equipment

Sunk Cost Occurred in the past & no relevance to estimate future costs & revenues related to an alternative course of action Common to all alternative, is not part of the future cash flows & disregarded in EE analysis Non-refundable cash outlays e.g earnest money on a house or money spent on a passport

Sunk Cost Example The firm is considering to replace of equipment. Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of replacement sunk cost is RM50,000. However on view is RM20,000 less RM5,000 is RM15,000. Neither RM50,000 or RM15,000 should be consider by EE analyze

Opportunity Cost Incurred due to the use of limited resources for monetary advantage in alternative use if foregone Cost of best rejected opportunity & often hidden or implied

Opportunity Cost Example The firm is considering to replace of equipment. Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of EE analysis, even to replace, by keeping the equipment, the new opportunity value of RM5,000 obtain from its disposal

Life-Cycle Cost Refers to a summation of all the costs related to a product, structure, system, or service during its life spin Begins with identification of the economic need/want & ends with retirement & disposal activities It is airtime horizon that must be defined in the context of the specific situation e.g. Highway, engine, aircraft, manufacturing etc Divided two general time periods; acquisition phase & operation phase

Phase Of The Life-Cycle & Relative Cost High Potential for life-cycle cost saving Cumulative life-cycle cost Cost (RM) Cumulative commited life-cycle cost Time Needs assessment: defination of requirement Conceptual (preliminary) design: advanced development prototype testing Details design production or construction planning: facility & resources accquisition Production or construction Operation or customer use: maintenance & support Retirement & disposal Acquisition Phase Operation Phase

Life-Cycle Cost - Acquisition phase Needs assessment: definition of requirement Analysis of the economic need/want Make explicit the requirement for the product, structure, system or service Conceptual (preliminary) design: advanced development prototype testing Proceed in a logical sequence Defined technical & operational requirement into proffered preliminary design

Life-Cycle Cost - Acquisition phase Details design production or contruction planning: facility & resource accquisition Details design & planning for production or construction Followed by activities necessary to prepare ,acquire & make ready for operation the facilities & other resources needed EE studies are an essential part of design process to analyze & compare alternatives & to assist in determing the final details design

Life-Cycle Cost - Operation phase Production or construction Operation or customer use: maintenance & support Retirement & disposal EE studies priorities Achieving efficient & effective support tooperation Determining replacement of assets should b occur Projecting the timing of retirement & disposal activities

Life-Cycle Cost - Categories Investment cost Capital required for most activities in the acquisition phase E.g. Single expenditure & series of expenditure Working capital cost Funds required for the start-up & support of operational activities E.g. Material for product/ spare part for maintenance/ cash for salaries etc

Life-Cycle Cost - Categories Operation & maintenance cost Includes many of the recurring annual expenses items associated with operation phase of LC Direct & indirect cost of operation associated with 5 primary resources (people/machines, materials/ energy/ information Disposal cost Includes those non-recurring costs of shutting down the operation & the retirement & disposal of assets at of LC

Classify each of the following cost items as mostly fixed or variable Quick Revision Classify each of the following cost items as mostly fixed or variable Raw Materials Direct Labour Depreciation Supplies Utilities Property taxes Interest on borrowing money Admin salaries Payroll taxes Insurance (building &equipment) Clerical salaries Sales Commissions Rent

Quiz 1 A group of EE team is making analysis in a decision to produce a new product in two alternative site. Details are as follows: Site A Site B Variable Cost (RM per unit) 1.40 1.00 Fixed Cost (RM per month) 6,500 9,000 Production Capacity (unit per month at single shift ) 10,000 20,000 Calculate:- Total Variable Cost (TVC) Total Production Cost (TPC) Total Cost (TC) Suggest the most economic site for production if the consumer demand is 20, 000 units per month, explain why?

Answer QUIZ 1 Q Site A Site B 1 Total Variable Cost (per shift) VC x TP RM1.40 x 10,000 = RM14,000 RM1.00 x 20,000 =RM20,000 2 Total Production Cost (per month) TVC x TPn RM14,000 x 2 = RM28,000 RM20,000 x 1 = RM20,000 3 Total Cost (per month) TPC + FC RM28,000 + RM6,500 = RM34,500 RM20,000 + RM9,000 = RM29,000 Recommendation by EE team: Site B is the most economic site because of lower cost of RM5,500 then Site A and able to fulfill the consumer demand

Thank You