1 Project Cost Elements and Income Tax Rate to Be Used Lecture No. 26 Professor C. S. Park Fundamentals of Engineering Economics Copyright © 2005

2 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 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 General Cost Terms Manufacturing Costs Direct materials Direct labor Mfg. Overhead Non-manufacturing Costs Overhead Marketing Administrative

5 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.

6 Cost Classification for Predicting Cost Behavior Volume index Cost Behaviors Fixed costs Variable costs Mixed costs Average unit costs

7 Volume Index Def: The unit measure used to define “volume” Examples:  Automobile – “miles” driven  Generating plant – “kWh” produced  Stamping machine – “parts” stamped

8 Fixed Costs Def: The costs of providing a company’s basic operating capacity Cost behavior: Remain constant over the relevant range

9 Variable Costs Def: Costs that vary depending on the level of production or sales Cost behavior: Increase or decrease proportionally according to the level of volume

10 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.

11 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

12 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 ?

13 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.

14 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) ($15,000/$20,000) = 31.75%