1. (c) 2002 Contemporary Engineering Economics 1 Chapter 3 Cost Concepts and Behaviors General Cost Terms Classifying Costs for Financial Statements Cost Classification for Predicting Cost Behaviors Cost Concepts Relevant to Decision-Making Thinking on the Margin: Fundamental Economic Decision-Making

2. (c) 2002 Contemporary Engineering Economics 2 Unit Price of an Ice Cream Cone

3. (c) 2002 Contemporary Engineering Economics 3 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.

4. (c) 2002 Contemporary Engineering Economics 4 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).

5. (c) 2002 Contemporary Engineering Economics 5 Classifying Costs for Uptown Ice Cream Shop Product Cost Period Cost Example 3.1

6. (c) 2002 Contemporary Engineering Economics 6 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

7. (c) 2002 Contemporary Engineering Economics 7 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. 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)

8. (c) 2002 Contemporary Engineering Economics 8 Fixed Costs or capacity cost Definition: The costs of providing a company’s basic operating capacity Cost behavior: Remain constant over the time but volume may change. Some examples; Annual insurance premium, property tax, and license fee, building rents, depreciation of buildings, salaries of administrative and production personnel.

9. (c) 2002 Contemporary Engineering Economics 9 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.

10. (c) 2002 Contemporary Engineering Economics 10 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

11. (c) 2002 Contemporary Engineering Economics 11 Cost Classification of Owning and Operating a Passenger Car

12. (c) 2002 Contemporary Engineering Economics 12 Cost-Volume Relationship

13. (c) 2002 Contemporary Engineering Economics 13 Cost-Volume Relationship

14. (c) 2002 Contemporary Engineering Economics 14 Average Cost per Mile

15. (c) 2002 Contemporary Engineering Economics 15 Differential (Incremental) Costs Definition: Difference in costs between any two alternatives known as Differential cost. Difference in revenues between any two alternatives is known as differential revenue.

16. (c) 2002 Contemporary Engineering Economics 16 Example 3.3: Differential Cost Associated with Adopting a New Production Method

17. (c) 2002 Contemporary Engineering Economics 17 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: $13,000 + 31.50Q Break-even volume: 36Q = $13,000 + 31.50Q Q = 3,000 units

18. (c) 2002 Contemporary Engineering Economics 18 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.

19. (c) 2002 Contemporary Engineering Economics 19 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.

20. (c) 2002 Contemporary Engineering Economics 20 Sunk Costs Definition:Cost that has already been incurred by past actions Economic Implications: Not relevant to future decisions Example: $500 spent to replace tires last year—not relevant in making selling decision in the future

21. (c) 2002 Contemporary Engineering Economics 21 Marginal Costs (example 3.6) Definition: Added costs that result from increasing rates of outputs, usually by single unit Example: Cost of electricity— decreasing marginal rate

22. (c) 2002 Contemporary Engineering Economics 22 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 = Sales price – Variable cost Application: Break-even volume analysis:

23. (c) 2002 Contemporary Engineering Economics 23 Marginal Analysis Principle: “Is it worthwhile?” Decision rule: To justify any course of action, Marginal revenue > Marginal cost

24. (c) 2002 Contemporary Engineering Economics 24 Example 3.7 Profit Maximization Problem

25. (c) 2002 Contemporary Engineering Economics 25 Summary General Cost Terms used in manufacturing: –Manufacturing costs Direct materials Direct labor Manufacturing overhead –Nonmanufacturing costs Administrative expenses Marketing Nonmanufacturing overhead

26. (c) 2002 Contemporary Engineering Economics 26 Classifying Costs for Financial Statements: –Period costs –Product costs Cost Classification for Predicating Cost Behaviors: –Fixed costs –Variable costs –Mixed costs

27. (c) 2002 Contemporary Engineering Economics 27 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.