1. Chapter 2 FUNDAMENTAL COST CONCEPTS
ENGINEERING ECONOMICS
(BPK 30902)
Chapter 2 FUNDAMENTAL COST CONCEPTS
ZUIKARNAIN DAUD

2. Contents Introduction Cost Terminology
Fixed Cost, Variable Costs and Total Costs
Recurring and Non-recurring Cost
Direct, Indirect and Standard Costs
Cash Cost versus Book Cost
Sunk Cost
Opportunity Cost
Life-Cycle Cost

3. Introduction
Cost terminology and concepts (the meaning and use of various cost terms and concepts) are important in engineering economy (EE) to be understood in order to communicate effectively with order engineering and management personnel
The use of present economy studies in engineering decision making can provide satisfactory results and save considerable analysis effort by considering the various monetary consequences that occur in short time period

4. Cost Terminology
A variety of costs that to be considered in EE analysis
Costs differ in frequency of accurrence, relative magnitude and degree of impact by defining a number of cost categories and illustrate how they should be treated

5. Fixed Cost, Variable Costs & Total Costs
Unaffected by changes in activity level feasible range in operation
E.g. Insurance, general management & admintrative salaries etc

6. Fixed Cost, Variable Costs & Total Costs
Those associated with operation that vary in total with quantity of output or other measure of activity level
E.g. Cost s of material & labor used in a product or service

7. Fixed Cost, Variable Costs & Total Costs
Sum of fixed costs & variable cost

8. Fixed Cost, Variable Costs & Total Costs
Exercise A group of EE study team is making analysis in a decision to produce a new product in two alternative site. Details are as follows:
Site A
Site B
Variable Cost (RM per unit)
1.20
0.90
Fixed Cost (RM per month)
5,000
7,500
Production Capacity (unit per month)
10,000
15,000

9. Fixed Cost, Variable Costs & Total Costs
Solution: The most economic total cost is RM1.40 per unit for site B due to the higher capacity of production of 15,000 unit per month. If the production is limited to 10,000 units per month, the total cost for Site B per unit is still lower at RM1.65 only compare to site A. However total cost needed for site B is RM21,000 per month compare to site A of RM17,000 per month only.
Site A
Site B
Variable Cost ( RM per month
12,000
13,500
Fixed Cost (RM per month)
5,000
7,500
Total Costs (RM per month)
17,000
21,000
Total Cost (per unit)
1.70
1.40
Total Costs at 10,000 unit output
16,500

10. Recurring and Nonrecurring Cost
Annual expenses items for direct & indirect cost associated with five primary resources
E.g. people, machines, materials, energy & information - major part expenses
Non-recurring Cost
Expenses for shutting down operation & retirement & disposal of assests
E.g. Personnal, materials, transportation etc

11. Direct, Indirect and Standard Costs
Direct costs
Costs that can be reasonably measured and allocated to a specific output or work activity
E.g. Labour & material costs directly associated with product, service or construction activity

12. Direct, Indirect and Standard Costs
Costs that are difficult to attribute or allocate to a specific output or work activity
E.g. Overhead include electricity, general repairs, supervision etc

13. Direct, Indirect and Standard Costs
Planned costs per unit of output that are establised in advance of actual production or sevice delivery
Developed from anticipated direct labour hours, materials & overhead categories (level of porduction)

14. Direct, Indirect and Standard Costs
Plays an important role & other management fuctions as
Estimating future manufacturing costs
Measuring operating performace by comparing actual cost per unit with standard unit cost
Preparing bid on product or service requested by customers
Establishing the value of work in process & finised inventories

15. Cash Cost versus Book Cost
A cost that involves payment of cash
Estimated from the perspective established for the analysis & are the future expenses incurred for the alternatives being analyzed
In EE analysis , only those costs that are cash flows or potential cash flows to be considered

16. Cash Cost versus Book Cost
Book cost (noncash cost)
A cost that does not involves a cash transaction and its relected in the accounting system
Represent the recovery of past expenditures over a fixed period of time
E.g. Depreciation (not a cash flows) charged on assets such as machines & equipment

17. Sunk Cost
Occurred in the past & no relevance to estimate future costs & revenues related to an alternative course of action
Common to all alternative, is not part of the future cash flows & disregarded in EE analysis
Non-refundable cash outlays e.g earnest money on a house or money spent on a passport

18. Sunk Cost
Example
The firm is considering to replace of equipment. Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of replacement sunk cost is RM50,000. However on view is RM20,000 less RM5,000 is RM15,000. Neither RM50,000 or RM15,000 should be consider by EE analyze

19. Opportunity Cost
Incurred due to the use of limited resources for monetary advantage in alternative use if foregone
Cost of best rejected opportunity & often hidden or implied

20. Opportunity Cost Example
The firm is considering to replace of equipment. Originally cost RM50,000. Book value is RM20,000 and selling price at RM5,000. For the purpose of EE analysis, even to replace, by keeping the equipment, the new opportunity value of RM5,000 obtain from its disposal

21. Life-Cycle Cost
Refers to a summation of all the costs related to a product, structure, system, or service during its life spin
Begins with identification of the economic need/want & ends with retirement & disposal activities
It is airtime horizon that must be defined in the context of the specific situation e.g. Highway, engine, aircraft, manufacturing etc
Divided two general time periods; acquisition phase & operation phase

22. Phase Of The Life-Cycle & Relative Cost
High
Potential for life-cycle cost saving
Cumulative life-cycle cost
Cost
(RM)
Cumulative commited life-cycle cost
Time
Needs assessment: defination of requirement
Conceptual (preliminary) design: advanced development prototype testing
Details design production or construction planning: facility & resources
accquisition
Production or construction
Operation or customer use: maintenance & support
Retirement & disposal
Acquisition Phase
Operation Phase

23. Life-Cycle Cost - Acquisition phase
Needs assessment: definition of requirement
Analysis of the economic need/want
Make explicit the requirement for the product, structure, system or service
Conceptual (preliminary) design: advanced development prototype testing
Proceed in a logical sequence
Defined technical & operational requirement into proffered preliminary design

24. Life-Cycle Cost - Acquisition phase
Details design production or contruction planning: facility & resource accquisition
Details design & planning for production or construction
Followed by activities necessary to prepare ,acquire & make ready for operation the facilities & other resources needed
EE studies are an essential part of design process to analyze & compare alternatives & to assist in determing the final details design

25. Life-Cycle Cost - Operation phase
Production or construction
Operation or customer use: maintenance & support
Retirement & disposal
EE studies priorities
Achieving efficient & effective support tooperation
Determining replacement of assets should b occur
Projecting the timing of retirement & disposal activities

26. Life-Cycle Cost - Categories
Investment cost
Capital required for most activities in the acquisition phase
E.g. Single expenditure & series of expenditure
Working capital cost
Funds required for the start-up & support of operational activities
E.g. Material for product/ spare part for maintenance/ cash for salaries etc

27. Life-Cycle Cost - Categories
Operation & maintenance cost
Includes many of the recurring annual expenses items associated with operation phase of LC
Direct & indirect cost of operation associated with 5 primary resources (people/machines, materials/ energy/ information
Disposal cost
Includes those non-recurring costs of shutting down the operation & the retirement & disposal of assets at of LC

28. Classify each of the following cost items as mostly fixed or variable
Quick Revision
Classify each of the following cost items as mostly fixed or variable
Raw Materials
Direct Labour
Depreciation
Supplies
Utilities
Property taxes
Interest on borrowing money
Admin salaries
Payroll taxes
Insurance (building &equipment)
Clerical salaries
Sales Commissions
Rent

29. Quiz 1
A group of EE team is making analysis in a decision to produce a new product in two alternative site. Details are as follows:
Site A
Site B
Variable Cost (RM per unit)
1.40
1.00
Fixed Cost (RM per month)
6,500
9,000
Production Capacity
(unit per month at single shift )
10,000
20,000
Calculate:-
Total Variable Cost (TVC)
Total Production Cost (TPC)
Total Cost (TC)
Suggest the most economic site for production if the consumer demand is 20, 000 units per month, explain why?

30. Answer QUIZ 1 Q
Site A
Site B 1
Total Variable Cost
(per shift)
VC x TP
RM1.40 x 10,000
= RM14,000
RM1.00 x 20,000
=RM20,000 2
Total Production Cost
(per month)
TVC x TPn
RM14,000 x 2
= RM28,000
RM20,000 x 1
= RM20,000 3
Total Cost (per month)
TPC + FC
RM28,000 + RM6,500
= RM34,500
RM20,000 + RM9,000 = RM29,000
Recommendation by EE team: Site B is the most economic site because of lower cost of RM5,500 then Site A and able to fulfill the consumer demand

31. Thank You