1 Understanding Project Cost Elements Lecture No. 22 Chapter 9 Fundamentals of Engineering Economics Copyright © 2008

2  Evaluation of a Fixed Asset –Equipment –Buildings  Valuation of Fixed Assets –Based on usable after-tax cash flows the asset produces Engineering Economic Decisions

3 Classifying Costs for Manufacturing Environment  Manufacturing Costs Direct Materials Direct Labor Mfg. Overhead  Non-manufacturing Costs Overhead Marketing Administrative Functions

4 Cost Flows and Classifications 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.

5 Classifying Costs for Predicting Cost Behavior  Volume index  Cost Behaviors  Fixed costs  Variable costs  Mixed costs  Break-Even Sales Volume

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

7 Fixed Costs  Def: The costs of providing a company’s basic operating capacity  Cost behavior: Remain constant over the relevant range  Typical examples: building rents, depreciation of buildings, machinery and equipment

8 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  Typical examples: direct labor cost, material cost, and fuel consumption

9 Mixed Costs  Def: a cost with both fixed and variable elements  Cost Behavior: y = a + bx, where “a” is a fixed cost  Typical examples: cost of electric power (lighting/heating/ac – fixed; power consumption by operating equipment – variable) Total cost Operating Volume, X a 0

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 Contribution Margin/Break-Even Sales Volume  Unit contribution margin  Unit contribution margin = unit sales price – unit variable cost  Contribution margin  Contribution margin = total sales revenue – total variable costs  Break-even sales volume

12 Example 9.1 Break-Even Sales Volume Monthly break-even point: Number of units to be sold to make $50,000 profit before tax:

13 Cost-Volume-Profit Graph

14 Why Do We Use Cash Flow in Project Evaluation? Company ACompany B Year 1Net income Cash flow $1,000,000 1,000,000 $1,000,000 0 Year 2Net income Cash flow 1,000,000 2,000,000 Example: Both companies (A & B) have the same amount of net income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 million at the end of 2 nd year. Company A can invest $1 million in year 1, while Company B has nothing to invest during the same period.

15 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 ?

16 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 evaluation. Incremental Income Tax Rate

17 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 the 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% Graphical Illustration of Incremental Tax Rate