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

OBJECTIVES Describe basic cost terminology Describe design economics

Cash flow Fixed Cost, Variable Cost, Incremental Cost Direct Cost, Indirect Cost, Standard Cost Cash Cost vs Book Cost Sunk Cost vs Opportunity Cost Life Cycle Cost Capital and Investment Recurring and Non-Recurring Cost Cost Estimating – 2 Approaches

Cash Flows A cash flow is a receipt or payment of an amount of money defined by 1) its dollar value and 2) the time of its occurrence Cash flow diagrams represent costs and revenues over time. Cost and Revenue estimation for the future always involve uncertainty.

FIXED, VARIABLE, AND INCREMENTAL COSTS Fixed costs are those unaffected by changes in activity level over a feasible range of operations for the capacity or capability available. Typical fixed costs include insurance and taxes on facilities, general management and administrative salaries, license fees, and interest costs on borrowed capital. When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected.

FIXED, VARIABLE AND INCREMENTAL COSTS Variable costs are those associated with an operation 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 in total with the number of output units -- even though costs per unit remain the same.

Example:

DIRECT, INDIRECT AND OVERHEAD COSTS Direct costs can be reasonably measured and allocated to a specific output or work activity -- labor and material directly allocated with a product, service or construction activity; Indirect costs are difficult to allocate to a specific output or activity -- costs of common tools, general supplies, and equipment maintenance ;

DIRECT, INDIRECT AND STANDARD COSTS Overhead consists of plant operating costs that are not direct labor or material costs indirect costs, overhead and burden are the same; E.g. electricity, general repairs Standard Cost is a planned cost per unit

CASH COST VERSUS BOOK COST A cash cost requires the cash transaction of dollars "out of one person's pocket" into "the pocket of someone else." When you buy dinner for your friends or make your monthly automobile payment you are incurring a cash cost or cash flow. Cash costs and cash flows are the basis for engineering economic analysis.

CASH COST VERSUS BOOK COST Book cost or noncash cost is a payment that does not involve cash transaction; book costs represent the recovery of past expenditures over a fixed period of time; Depreciation is the most common example of book cost; depreciation is what is charged for the use of assets, such as plant and equipment; depreciation is not a cash flow; it is important as depreciation affect income taxes, and subsequently affects the cash flow as well

SUNK COST AND OPPORTUNITY COST A sunk cost is money already spent as a result of a past decision. Sunk costs should be disregarded in our engineering economic analysis because current decisions cannot change the past.

SUNK COST AND OPPORTUNITY COST For example, dollars spent last year to purchase new production machinery is money that is sunk: the money allocated to purchase the production machinery has already been spent-there is nothing that can be done now to change that action.

SUNK COST AND OPPORTUNITY COST Many times it is difficult not to be influenced by sunk costs. Consider 100 shares of stock in XYZ, Inc., purchased for $15 per share last year. The share price has steadily declined over the past 12months to a price of $10 per share today. Current decisions must focus on the $10 per share that could be attained today (as well as future price potential), not the $15 per share that was paid last year. The $15 per share paid last year is a sunk cost and has no influence on present opportunities.

SUNK COST AND OPPORTUNITY COST As another example, when Regina was a sophomore, she purchased a newest-generation laptop from the college bookstore for $2000. By the time she graduated, the most anyone would pay her for the computer was $400 because the newest models were faster, cheaper and had more capabilities. For Regina the original purchase price was a sunk cost that has no influence on her present opportunity to sell the laptop at its current market value ($400).

SUNK COST AND OPPORTUNITY COST An opportunity cost is associated with using a resource in one activity instead of another. Every time we use a business resource (equipment, dollars,manpower, etc.) in one activity, we give up the opportunity to use the same resources at that time in some other activity.

SUNK COST AND OPPORTUNITY COST Every day businesses use resources to accomplish various tasks-forklifts are used to transport materials, engineers are used to design products and processes, assembly lines are used to make a product, and parking lots are used to provide parking for employees' vehicles. Each of these resources costs the company money to maintain for those intended purposes. However, that cost is not just made up of the dollar cost, it also includes the opportunity cost. Each resource that a firm owns can feasibly be used in several alternative ways. For instance, the assembly line could produce a different product, and the parking lot could be rented out, used as a building site, or converted into a small airstrip. Each of these alternative uses would provide some benefit to the company.

SUNK COST AND OPPORTUNITY COST Your grandmother owns her home, but lives with your parents. She rents her $185,000-house for $400/month. Good idea or lost opportunity? An opportunity cost is the benefit that is forgone by engaging a business resource in a chosen activity instead of engaging that same resource in the forgone activity.

SUNK COST AND OPPORTUNITY COST Example, suppose that friends invite a college student to travel through Europe over the summer break. In considering the offer, the student might calculate all the out-of-pocket cash costs that would be incurred. Cost estimates might be made for items such as air travel, lodging, meals, entertainment, and train passes. Suppose this amounts to $3000 for a to-week period. After checking his bank account, the student reports that indeed he can afford the $3000 trip.

SUNK COST AND OPPORTUNITY COST However, the true cost to the student includes not only his out-of-pocket cash costs but also his opportunity cost. By taking the trip, the student is giving up the opportunity to earn $5000 as a summer intern at a local business. The student's total cost will comprise the $3000 cash cost as well as the $5000 opportunity cost (wages forgone)-the total cost to our traveler is thus $8000.

LIFE-CYCLE COST Life-cycle cost is the summation of all costs, related to a product, structure, system, or service during its life span. Life cycle begins with the identification of the economic need or want ( the requirement ) and ends with the retirement and disposal activities.

LIFE-CYCLE COST The products, goods, and services designed by engineers all progress through a life cycle very much like the human life cycle. People are conceived, go through a growth phase, reach their peak during maturity, and then gradually decline and expire. The same general pattern holds for products, goods, and services. As with humans, the duration of the different phases, the height of the peak at maturity, and the time of the onset of decline and termination all vary depending on the individual product, good, or service. Figure 2-1 illustrates the typical phases that a product, good or service progresses through over its life cycle.

Figure 2-1 Phases of the Life Cycle and Their Relative Cost

LIFE-CYCLE COST Life-cycle costing refers to the concept of designing products, goods, and services with a full and explicit recognition of the associated costs over the various phases of their life cycles. Two key concepts in life-cycle costing are that the later design changes are made, the higher the costs, and that decisions made early in the life cycle tend to "lock in" costs that are incurred later. Figure 2-2 illustrates how costs are committed early in the product life cycle-nearly 70-90% of all costs are set during the design phases. At the same time, as the figure shows, only 10-30% of cumulative life-cycle costs have been spent.

LIFE-CYCLE COST FIGURE 2-4 Cumulative life-cycle costs committed and dollars spent.

LIFE-CYCLE COST FIGURE 2-3 Life-cycle design change costs and ease of change.

LIFE-CYCLE COST Figure 2-3 reinforces these concepts by illustrating that downstream product changes' are more costly and that upstream changes are easier (and less costly) to make. When planners try to save money at an early design stage, the result is often a poor design, calling for change orders during construction and prototype development. These changes, in turn, are more costly than working out a better design would have been.

LIFE-CYCLE COST From the figures we see that the time to consider all life-cycle effects, and make design changes, is during the needs and conceptual/preliminary design phases-before a lot of dollars are committed. Some of the life-cycle effects that engineers should consider at design time include product costs for liability, production, material, testing and quality assurance, and maintenance and warranty. Other life-cycle effects include product features based on customer input and product disposal effects on the environment. The key point is that engineers who design products and the systems that produce them should consider all life-cycle costs.

LIFE-CYCLE COST Several basic life cycle cost categories Investment cost – capital required for most activities in the acquisition phase. also known as Capital investment 2) Working capital – funds to required for current assets. Tools, spare part, salary 3) Operation and Maintenance cost-recurring annual expense item associated with the operation phase of life cycle 4) Disposal cost – non-recurring costs of shutting down the operation and disposal of assets at the end of life cycle. E.g- cleaning site