(c) 2002 Contemporary Engineering Economics 1 Chapter 3 Cost Concepts and Behaviors

(c) 2002 Contemporary Engineering Economics 2 Topics to Cover General Cost Terms Classifying Costs for Financial Statements Cost Classification for Predicting Cost Behaviors

(c) 2002 Contemporary Engineering Economics 3 Topics to Cover Thinking on the Margin: Fundamental Economic Decision- Making

(c) 2002 Contemporary Engineering Economics 4 An Example We will start with an example to understand the concepts covered in this chapter The example is of a ice-cream producer producing ice-cream cones “Uptown Ice Cream Shop”

(c) 2002 Contemporary Engineering Economics 5 Unit Price of an Ice Cream Cone: Uptown Ice Cream Shop / 0.65 = Or 9250/ 0.05 = Or … Cones

(c) 2002 Contemporary Engineering Economics 6 General Cost Terms

(c) 2002 Contemporary Engineering Economics 7 General Cost Terms Manufacturing Costs Direct materials Direct labor Mfg. Overhead include Indirect materials, indirect labor; maintenance and Repairs on production equipment; heat and light; property taxes; depreciation; insurance, etc., Non-manufacturing Costs Overhead Heat and light, property taxes, depreciation Marketing or selling Advertising, shipping, sales travel, sales salaries Administrative Executive compensation, general accounting, Public relations, and secretarial support.

(c) 2002 Contemporary Engineering Economics 8 Classifying Costs for Financial Statements In financial accounting, the Matching Concept states that 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 charged to expenses in the time period basis (advertising, executive salaries, sales commissions, public relations, other non manufacturing costs). Product costs:Those costs that are involved in the purchase or manufacturing of goods. Since product costs are assigned to inventories, known as inventory costs. (all costs related to manufacturing process).

(c) 2002 Contemporary Engineering Economics 9 Classifying Costs for Uptown Ice Cream Shop Product Cost Period Cost Example 3.1

(c) 2002 Contemporary Engineering Economics 10 Cost Flows and Classifications in a Mfg. Co. Cost of revenue = Cost of goods sold Raw materials inventory Work-in-process inventory Finished goods inventory

(c) 2002 Contemporary Engineering Economics 11 Cost Classification for Predicting Cost Behavior (describes how cost item will respond to changes in the level of business activity) Volume index Operating cost respond in some way to changes in its operating volume. Need to determine some measurable volume or activity which has strong Influence on the amount of cost incurred. (volume index may be based on production inputs/out puts. Energy consumption, labor hours OR KWhr generated or miles per year driven by a car) Cost Behaviors Fixed costs Variable costs Mixed costs In the car case, Depreciation, occur from passage of time (fixed portion) and also More miles are driven a year, loses its Market value (variable portion) Average unit costs (example: 3.2 Calculating average cost per mile)

(c) 2002 Contemporary Engineering Economics 12 Volume index: It is necessary to distinguish between changes arising solely from price changes and those arising from other influences such as quantity and quality, which are referred to as changes in “volume”. A volume index is presented as a weighted average of the proportionate changes in the quantities of a specified set of goods or services between two periods of time. The quantities compared must be homogeneous, while the changes for different goods and services must be weighted by their economic importance as measured by their values in one or other, or both, periods.

(c) 2002 Contemporary Engineering Economics 13 Volume index: (Illustrated Example) Consider an industry that produces two different models of automobile, one selling for twice the price of the other. From an economic point of view these are two quite different products even though described by the same generic term "automobile". Suppose that between two periods of time: (a) The price of each model remains constant; (b) The total number of automobiles produced remains constant; (c) The proportion of higher priced models produced increases from 50 % to 80 %.It follows that: – the total value of the output produced increases by 20 % because of the increase in the proportion of higher-priced models. This constitutes a volume increase of 20 %. As each higher-priced automobile constitutes twice as much output as each lower-priced automobile, a switch in production from low- to high-priced models increases the volume of output even though the total number of automobiles produced remains unchanged. The fact that the value increase is entirely attributable to an increase in volume also follows from the fact that no price change occurs for either model. The price index must remain constant in these circumstances. cost cheaper * 50 + cost expansive * 50 Before: 1 * * 50 =150  After: 1* * 80 = = /150 * 100 = 20% increase in volume index.

(c) 2002 Contemporary Engineering Economics 14 Fixed Costs or capacity cost Definition: The costs of providing a company’s basic operating capacity Cost behavior: Remain constant over the time though volume may change. Some examples; Annual insurance premium, property tax, and license fee, building rents, depreciation of buildings, salaries of administrative and production personnel.

(c) 2002 Contemporary Engineering Economics 15 Variable Costs Definition: Costs that vary depending on the level of production or sales Cost behavior: Increase or decrease according to the level of volume change. Example: Ice cream cone company, wages, payroll taxes, sales tax, and supplies. Fuel consumption is directly related to miles driven.

(c) 2002 Contemporary Engineering Economics 16 Average Unit Cost Definition: activity cost on a per unit basis Cost Behaviors: –Fixed cost per unit varies with changes in volume. –Variable cost per unit of volume is constant. See example 3.2

(c) 2002 Contemporary Engineering Economics 17 Cost Classification of Owning and Operating a Passenger Car

(c) 2002 Contemporary Engineering Economics 18 Cost-Volume Relationship

(c) 2002 Contemporary Engineering Economics 19 Cost-Volume Relationship $ M

(c) 2002 Contemporary Engineering Economics 20 Average Cost per Mile

(c) 2002 Contemporary Engineering Economics 21 Cost Concepts relevant to the decision making. Costs are an important feature of many business decisions. In order to make such decisions following cost needed to be well understood… –Differential costs –Opportunity costs –Sunk costs –Marginal costs

(c) 2002 Contemporary Engineering Economics 22 Differential (Incremental) Costs Revenues Decision involve selection among alternatives. Each alternative have certain costs / benefits that are needed to be compared to the costs / benefits of the other alternatives

(c) 2002 Contemporary Engineering Economics 23 Differential (Incremental) Costs and Revenues Definition: Difference in costs between any two alternatives known as Differential cost. Difference in revenues between any two alternatives is known as differential revenue.

(c) 2002 Contemporary Engineering Economics 24 Differential (Incremental) Costs Revenues Cost-volume relationship based on differential costs find many engineering applications such as short term decision making. Example: The base case is the status quo (current operation). We propose an alt. to the base case. If alt. has lower cost we accept the alt. assuming non- quantitative factors do not offset the cost advantage.

(c) 2002 Contemporary Engineering Economics 25 Differential (Incremental) Costs Revenues Differential cost = difference in total cost that results from selecting one alt. instead of the other. Problem of this type are generally called trade off problems because one type of cost is traded by another type of cost KEY FEATURES: New investment in physical assest not required, planning horizon short, relatively few cost items are subject to change by the decision

(c) 2002 Contemporary Engineering Economics 26 Differential (Incremental) Costs Revenues Common examples: Method change – Example 3.3 page 75 Operations planning – Example 3.4 page 76 Make or buy decision – Example 3.5 page 77

(c) 2002 Contemporary Engineering Economics 27 Example 3.3: Differential Cost Associated with Adopting a New Production Method

(c) 2002 Contemporary Engineering Economics 28 Example 3.4 Break-Even Volume Analysis In typical manufacturing environment, when demand is high, managers are interested in whether to use a one-shift plus overtime operations or to add a second shift. When demand is low, it is possible to explore whether to operate temporarily at a very low volume or to shut down until operations at normal volume become economical. In a chemical plant, several routes exist for scheduling products through the plant. The problem is in which route provides the lowest cost. Option 1: Adding overtime or Saturday operations: 36Q Option 2: Second-shift operation: $13, Q Break-even volume: 36Q = $13, Q Q = 3,000 units

(c) 2002 Contemporary Engineering Economics 29 Example 3.5 -Make or Buy Many firms perform certain activities using their own resources, and pay outside firms to perform certain other activities. It is a good policy to constantly seek to improve the balance between these two types of activities.

(c) 2002 Contemporary Engineering Economics 30 Opportunity Costs Definition: The potential benefit that is given up as you seek an alternative course of action Example: When you decide to pursue a college degree, your opportunity cost would include the 4- year’s potential earnings foregone.

(c) 2002 Contemporary Engineering Economics 31 Sunk Costs Definition: Cost that has already been incurred by past actions Economic Implications: Not relevant to future decisions Example: $200 spent to replace water-pump last year—not relevant in making selling decision in the future

(c) 2002 Contemporary Engineering Economics 32 Marginal Analysis Principle: “Is it worthwhile?” Decision rule: To justify any course of action, Marginal revenue > Marginal cost

(c) 2002 Contemporary Engineering Economics 33 Marginal Costs (example 3.6) Definition: Added costs that result from increasing rates of outputs, usually by single unit Example 3.6: Cost of electricity—decreasing marginal rate Compare it with Differential cost (Account’s) / Marginal (Economist’s)

(c) 2002 Contemporary Engineering Economics 34 Unit Marginal Contribution (MC) Definition: Difference between the unit sales price and the unit variable cost, also known as marginal income or producer’s marginal contribution (MC). This means each unit sold contributes toward absorbing the company’s fixed cost. MC = U Sales price – U Variable cost Application: Break-even volume analysis:

(c) 2002 Contemporary Engineering Economics 35 Example 3.7 Profit Maximization Problem

(c) 2002 Contemporary Engineering Economics 36 Summary General Cost Terms used in manufacturing: –Manufacturing costs Direct materials Direct labor Manufacturing overhead –Nonmanufacturing costs Administrative expenses Marketing Nonmanufacturing overhead

(c) 2002 Contemporary Engineering Economics 37 Classifying Costs for Financial Statements: –Period costs –Product costs Cost Classification for Predicating Cost Behaviors: –Fixed costs –Variable costs –Mixed costs

(c) 2002 Contemporary Engineering Economics 38 Cost Concepts Relevant to Decision-Making –Differential cost and revenue –Opportunity costs –Sunk costs –Marginal costs Thinking on the Margin: Fundamental Economic Decision-Making: –The basic question to any economic decision: Is it worthwhile? –Marginal revenues must exceed marginal costs.