1. CHAPTER 2 COST CONCEPTS AND DESIGN ECONOMICS

2. OBJECTIVES Describe basic cost terminologyDescribe basic cost terminology Describe design economicsDescribe design economics

3. 3 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 occurrenceA 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.Cash flow diagrams represent costs and revenues over time. Cost and Revenue estimation for the future always involve uncertainty.Cost and Revenue estimation for the future always involve uncertainty.

4. COST ESTIMATING Used to describe the process by which the present and future cost consequences of engineering designs are forecast

5. COST ESTIMATING USED TO Provide information used in setting a selling price for quoting, bidding, or evaluating contractsProvide information used in setting a selling price for quoting, bidding, or evaluating contracts Determine whether a proposed product can be made and distributed at a profit (EG: price = cost + profit)Determine whether a proposed product can be made and distributed at a profit (EG: price = cost + profit) Evaluate how much capital can be justified for process changes or other improvementsEvaluate how much capital can be justified for process changes or other improvements Establish benchmarks for productivity improvement programsEstablish benchmarks for productivity improvement programs

6. COST ESTIMATING APPROACHES Top-down ApproachTop-down Approach Bottom-up ApproachBottom-up Approach

7. TOP-DOWN APPROACH Uses historical data from similar engineering projectsUses historical data from similar engineering projects Used to estimate costs, revenues, and other parameters for current projectUsed to estimate costs, revenues, and other parameters for current project Modifies original data for changes in inflation / deflation, activity level, weight, energy consumption, size, etc…Modifies original data for changes in inflation / deflation, activity level, weight, energy consumption, size, etc… Best use is early in estimating processBest use is early in estimating process

8. 8 Top-Down Estimate The first step in the determination of the cash flows is the estimation of costs and revenues.The first step in the determination of the cash flows is the estimation of costs and revenues. The top-down approach takes data from similar projects and modifies them to reflect the current project.The top-down approach takes data from similar projects and modifies them to reflect the current project. –Estimate your cost of a college degree: use the cost of your brother’s degree three years ago and adjust it for inflation. Add $5000 for the cost of your participation in extra curricular activities (your brother was a bookworm)

9. BOTTOM-UP APPROACH More detailed cost-estimating methodMore detailed cost-estimating method Attempts to break down project into small, manageable units and estimate costs, etc….Attempts to break down project into small, manageable units and estimate costs, etc…. Smaller unit costs added together with other types of costs to obtain overall cost estimateSmaller unit costs added together with other types of costs to obtain overall cost estimate Works best when detail concerning desired output defined and clarifiedWorks best when detail concerning desired output defined and clarified

10. 10 Bottom-Up Estimates The bottom-up approach is more detailed, breaking down the project in small manageable units and estimating the cost of the parts first.The bottom-up approach is more detailed, breaking down the project in small manageable units and estimating the cost of the parts first. –Bottom-Up: Break down anticipated expenses in categories: tuition and fees, books and supplies, living expenses, transportation and estimate each as accurately as possible.

11. 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.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

12. 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;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;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; 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;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;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;

13. 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.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.

14. 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.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.

15. 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.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.

16. 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).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).

17. SUNK COST AND OPPORTUNITY COST An opportunity cost is associated with using a resource in one activity instead of another.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.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. An opportunity cost is associated with using a resource in one activity instead of another.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.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.

18. 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.

19. 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?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.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. Your grandmother owns her home, but lives with your parents. She rents her $185,000-house for $400/month. Good idea or lost opportunity?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.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.

20. 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.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

21. 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.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. SUNK COST AND OPPORTUNITY COST

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

23. The products, goods, and services designed by engineers all progress through a life cycle very much like the human life cycle.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.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 2-3 illustrates the typical phases that a product, good or service progresses through over its life cycle.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 2-3 illustrates the typical phases that a product, good or service progresses through over its life cycle. LIFE-CYCLE COST

24. FIGURE 2-3 Typical life cycle for products, goods and services.

25. 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.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.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 2-4 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.Figure 2-4 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.

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

27. LIFE-CYCLE COST FIGURE 2-5 Life-cycle design change costs and ease of change.

28. LIFE-CYCLE COST Figure 2-5 reinforces these concepts by illustrating that downstream product changes' are more costly and that upstream changes are easier (and less costly) to make.Figure 2-5 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.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.

29. LIFE-CYCLE COST From Figures2-4 and 2-5 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.From Figures2-4 and 2-5 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....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....

30. CAPITAL AND INVESTMENT Investment Cost or capital investment is the capital (money) required for most activities of the acquisition phase;Investment Cost or capital investment is the capital (money) required for most activities of the acquisition phase; Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities;Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities; Operation and Maintenance Cost includes many of the recurring annual expense items associated with the operation phase of the life cycle;Operation and Maintenance Cost includes many of the recurring annual expense items associated with the operation phase of the life cycle; Disposal Cost includes non-recurring costs of shutting down the operation;Disposal Cost includes non-recurring costs of shutting down the operation; Investment Cost or capital investment is the capital (money) required for most activities of the acquisition phase;Investment Cost or capital investment is the capital (money) required for most activities of the acquisition phase; Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities;Working Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities; Operation and Maintenance Cost includes many of the recurring annual expense items associated with the operation phase of the life cycle;Operation and Maintenance Cost includes many of the recurring annual expense items associated with the operation phase of the life cycle; Disposal Cost includes non-recurring costs of shutting down the operation;Disposal Cost includes non-recurring costs of shutting down the operation;

31. 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 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.

32. 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. 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.

33. RECURRING AND NONRECURRING COSTS Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis.Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis. Variable costs are recurring costs because they repeat with each unit of output.Variable costs are recurring costs because they repeat with each unit of output. A fixed cost that is paid on a repeatable basis is also a recurring cost:A fixed cost that is paid on a repeatable basis is also a recurring cost: –Office space rental Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis.Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis. Variable costs are recurring costs because they repeat with each unit of output.Variable costs are recurring costs because they repeat with each unit of output. A fixed cost that is paid on a repeatable basis is also a recurring cost:A fixed cost that is paid on a repeatable basis is also a recurring cost: –Office space rental $

34. RECURRING AND NONRECURRING COSTS Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time;Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time; Typically involve developing or establishing a capability or capacity to operate;Typically involve developing or establishing a capability or capacity to operate; Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself;Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself; Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time;Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time; Typically involve developing or establishing a capability or capacity to operate;Typically involve developing or establishing a capability or capacity to operate; Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself;Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself;

35. 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;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 ;Indirect costs are difficult to allocate to a specific output or activity -- costs of common tools, general supplies, and equipment maintenance ; 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;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 ;Indirect costs are difficult to allocate to a specific output or activity -- costs of common tools, general supplies, and equipment maintenance ;

36. Overhead consists of plant operating costs that are not direct labor or material costsOverhead consists of plant operating costs that are not direct labor or material costs – indirect costs, overhead and burden are the same; Prime Cost is a common method of allocating overhead costs among products, services and activities in proportion the sum of direct labor and materials cost ;Prime Cost is a common method of allocating overhead costs among products, services and activities in proportion the sum of direct labor and materials cost ; Overhead consists of plant operating costs that are not direct labor or material costsOverhead consists of plant operating costs that are not direct labor or material costs – indirect costs, overhead and burden are the same; Prime Cost is a common method of allocating overhead costs among products, services and activities in proportion the sum of direct labor and materials cost ;Prime Cost is a common method of allocating overhead costs among products, services and activities in proportion the sum of direct labor and materials cost ; DIRECT, INDIRECT AND OVERHEAD COSTS

37. STANDARD COSTS Representative costs per unit of output that are established in advance of actual production and service delivery;Representative costs per unit of output that are established in advance of actual production and service delivery; Standard Cost ElementSources of Data Direct LaborProcess routing sheets, +standard times, standard labor rates; Direct MaterialMaterial quantities per +unit, standard unit materials cost; Factory Overhead CostsTotal factory overhead costs allocated based on prime costs; Representative costs per unit of output that are established in advance of actual production and service delivery;Representative costs per unit of output that are established in advance of actual production and service delivery; Standard Cost ElementSources of Data Direct LaborProcess routing sheets, +standard times, standard labor rates; Direct MaterialMaterial quantities per +unit, standard unit materials cost; Factory Overhead CostsTotal factory overhead costs allocated based on prime costs;

38. SOME STANDARD COST USES Estimating future manufacturing or service delivery costs;Estimating future manufacturing or service delivery costs; Measuring operating performance by comparing actual cost per unit with the standard unit cost;Measuring operating performance by comparing actual cost per unit with the standard unit cost; Preparing bids on products or services requested by customers;Preparing bids on products or services requested by customers; Establishing the value of work-in-process and finished inventories;Establishing the value of work-in-process and finished inventories; Estimating future manufacturing or service delivery costs;Estimating future manufacturing or service delivery costs; Measuring operating performance by comparing actual cost per unit with the standard unit cost;Measuring operating performance by comparing actual cost per unit with the standard unit cost; Preparing bids on products or services requested by customers;Preparing bids on products or services requested by customers; Establishing the value of work-in-process and finished inventories;Establishing the value of work-in-process and finished inventories;

39. FIXED,VARIABLE AND INCREMENTAL COSTS incremental cost is the additional cost that results from increasing the output of a system by one (or more) units. Incremental cost is often associated with “go / no go” decisions that involve a limited change in output or activity level. EXAMPLE the incremental cost of driving an automobile might be $0.27 / mile. This cost depends on: – –mileage driven; – –mileage expected to drive; – –age of car; incremental cost is the additional cost that results from increasing the output of a system by one (or more) units. Incremental cost is often associated with “go / no go” decisions that involve a limited change in output or activity level. EXAMPLE the incremental cost of driving an automobile might be $0.27 / mile. This cost depends on: – –mileage driven; – –mileage expected to drive; – –age of car;

40. CONSUMER GOODS AND PRODUCER GOODS AND SERVICES Consumer goods and services are those that are directly used by people to satisfy their wants;Consumer goods and services are those that are directly used by people to satisfy their wants; Producer goods and services are those used in the production of consumer goods and services: machine tools, factory buildings, buses and farm machinery are examples;Producer goods and services are those used in the production of consumer goods and services: machine tools, factory buildings, buses and farm machinery are examples; Consumer goods and services are those that are directly used by people to satisfy their wants;Consumer goods and services are those that are directly used by people to satisfy their wants; Producer goods and services are those used in the production of consumer goods and services: machine tools, factory buildings, buses and farm machinery are examples;Producer goods and services are those used in the production of consumer goods and services: machine tools, factory buildings, buses and farm machinery are examples;

41. GENERAL APPROACH FOR OPTIMIZING A DESIGN WITH RESPECT TO COST 1.Identify primary cost-driving design variable 2.Write an expression for the cost model in terms of the design variable 3.Set first derivative of cost model with respect to continuous design variable equal to 0. (For discrete design variables, compute cost model for each discrete value over selected range). 4.Solve equation in step 3 for optimum value of continuous design variables 5.For continuous design variables, use the second derivative of the cost model with respect to the design variable to determine whether optimum corresponds to global maximum or minimum.

42. PRESENT ECONOMY STUDIES When alternatives for accomplishing a task are compared for one year or less (I.e., influence of time on money is irrelevant) Rules for Selecting Preferred Alternative Rule 1 – When revenues and other economic benefits are present and vary among alternatives, choose alternative that maximizes overall profitability based on the number of defect-free units of output Rule 2 – When revenues and economic benefits are not present or are constant among alternatives, consider only costs and select alternative that minimizes total cost per defect-free output

43. PRESENT ECONOMY STUDIES Total Cost in Material Selection In many cases, selection of among materials cannot be based solely on costs of materials. Frequently, change in materials affect design, processing, and shipping costs. Alternative Machine Speeds Machines can frequently be operated at different speeds, resulting in different rates of product output. However, this usually results in different frequencies of machine downtime. Such situations lead to present economy studies to determine preferred operating speed.

44. PRESENT ECONOMY STUDIES Make Versus Purchase (Outsourcing) Studies A company may choose to produce an item in house, rather than purchase from a supplier at a price lower than production costs if: 1.direct, indirect or overhead costs are incurred regardless of whether the item is purchased from an outside supplier, and 2.The incremental cost of producing the item in the short run is less than the supplier’s price The relevant short-run costs of the make versus purchase decisions are the incremental costs incurred and the opportunity costs of resources

45. PRESENT ECONOMY STUDIES Make Versus Purchase (Outsourcing) Studies Opportunity costs may become significant when in-house manufacture of an item causes other production opportunities to be foregone (E.G., insufficient capacity)Opportunity costs may become significant when in-house manufacture of an item causes other production opportunities to be foregone (E.G., insufficient capacity) In the long run, capital investments in additional manufacturing plant and capacity are often feasible alternatives to outsourcing.In the long run, capital investments in additional manufacturing plant and capacity are often feasible alternatives to outsourcing.