COST ESTIMATE, ELEMENTS OF

COST & BREAK-EVEN

ANALYSIS
(Lecture 2)
Used to describe the process by
which the present and future cost
consequences of engineering
designs are forecast
 Provide 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)
 Evaluate how much capital can be
justified for process changes or other
improvements
 Establish benchmarks for productivity
improvement programs
Top-down Approach
Bottom-up Approach
 Uses historical data from similar
engineering projects
 Used 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…
 Best use in early estimating process
 More detailed cost-estimating method
 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 estimate
 Works best when detail concerning
desired output defined and clarified
 Cash cost is a cost that involves payment in
cash and results in 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;
 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;
SUNK COST AND OPPORTUNITY COST
 A sunk cost is one that has occurred in
the past and has no relevance to
estimates of future costs and revenues
related to an alternative course of
action;
 An opportunity cost is the cost of the
best rejected opportunity and is hidden
or implied;
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 begins with the identification of the
economic need or want ( the requirement ) and
ends with the retirement and disposal
activities.
 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;

 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;
DEMAND – is the quantity of a certain commodity that
is bought at a certain price at a given place and
time.

SUPPLY – is the quantity of a certain commodity that

is offered for sale at a certain price at a given place
and time.

FIXED COST – are costs that do not vary in proportion

to the quantity of output.

VARIABLE COST – are costs that vary in proportion to

quantity of output.

BREAK EVEN POINT – is the level of production at

which revenue is exactly equal to total costs
 Elements of Cost:
1. Materials
a) Direct Materials are those which are used in the
finished product itself.
b) Indirect Materials are those materials used in
production but which do not go into the finished
product.

2. Labor
a) Direct Labor is the actual work applied directly
to the manufacture of the product
b) Indirect Labor is the work necessary for the
operation of the factory, but which cannot be
identified with one particular process or product
manufactured.
3. Overhead Expenses
Expenses which cannot be allocated to direct
materials or direct labor.

PRIME COST = Direct Materials Cost + Direct Labor

Cost

PRODUCTION COST = Direct Materials Cost +

Direct Labor Cost + Overhead Cost
Or
PRODUCTION COST = Prime Cost + Overhead Cost
Sample of Overhead Cost (Indirect Labor /
Indirect Materials)
• Indirect Materials ~ Company Supplies
• Indirect Labor ~ Headoffice / Warehouse
• Employee Benefits
• Rent
• Utilities
• Office Expenses
• Repairs & Maintenance
• Insurance
• Taxes
• Depreciation
LAW OF SUPPLY
The law of supply is a
fundamental principle of
economic theory which
states that, keeping other
factors constant, an
increase in price results in
an increase in quantity
supplied.

In other words, there is a

direct relationship between
price and quantity:
quantities respond in the
same direction as price
changes.
LAW OF DEMAND

The law of demand

states that other factors
being constant, price
and quantity demand
of any good and
service are inversely
related to each other.

When the price of a

product increases, the
demand for the same
product will fall.
LAW OF DEMAND AND
SUPPLY
The law of supply and demand
is a theory that explains the
interaction between the supply
of a resource and the demand
for that resource. The theory
defines the effect that the
availability of a particular
product and the desire (or
demand) for that product has
on its price.

Generally, low supply and high

demand increase price. In
contrast, the greater the supply
and the lower the demand, the
price tends to fall.
The relationship between price and demand can
be expressed as a line
p
r p = a - bD
i
c
e

Demand (D)
Where a is the intercept on the price (p)axis and
–b is the slope.
 R Peak point – represents the
T e Maximum revenue
O v
T e
A n
L u
e Demand that maximizes
Total Revenue
TR  pD
TR  (a  bD) D D'
Volume (D)
or
TR  aD  bD 2
 Total Cost
TC  TVC  TFC
TC  vcD  TFC
C Variable Cost
o
s
t Fixed Cost

Volume (D)
 R
e Represents the
C v Maximum Profit
o e
st or Total Cost
n
u *
D
a  vc
2b

e
Demand that maximizes
Total Profit

D*

Volume (D)
BREAKEVEN ANALYSIS
Types of Cost
Fixed costs (FC). These include costs such as
buildings, insurance, fixed overhead, some
minimum level of labor, equipment capital recovery,
and information systems.

The fixed-cost component is essentially constant for

all values of the variable, so it does not vary
for a large range of operating parameters, such as
production level or workforce size. Even if no
units are produced, fixed costs are incurred at some
threshold level
BREAKEVEN ANALYSIS

Types of Cost
Variable costs (VC). These include costs such as
direct labor, materials, indirect costs, contractors,
marketing, advertisement, and warranty.

Variable costs change with production level,

workforce size, and other parameters. It is usually
possible to decrease variable costs through better
product design, manufacturing efficiency,
improved quality and safety, and higher sales
volume
BREAKEVEN ANALYSIS

Total Cost = Fixed Cost + Variable Cost

When FC and VC are added, they form the TOTAL
COST relation TC

A. Linear b. Non Linear

Note: unit variable costs
decrease as the quantity level
rises
A. FOR PRICE IS NOT CONSTANT
Formulas: p  a  bD
Price:
TR  pD
Total Revenue: TR  (a  bD) D
or
TR  aD  bD 2
TC  TVC  TFC
Total Cost :
TC  vcD  TFC
Profit: P  TR  TC
P  pD  (vcD  TFC )
P  (a  bD) D  vcD  TFC
P  bD 2  (a  vc) D  TFC

Demand that maximizes Revenue a

D
2b
Demand that maximizes Profit * a vc
(Optimum Profit) D  2b
Break even points: Profit = 0
P  TR  TC
P  pD  (vcD  TFC )
P  (a  bD) D  vcD  TFC
P  bD 2  (a  vc) D  TFC
0  bD 2  (a  vc) D  TFC

 ( a  vc)  ( a  vc) 2
 4(b)(TFC )
D 
'

2(b)
B. FOR PRICE IS CONSTANT

Break even point: TFC

D '

p  vc
R D' 
TFC
C p  vc
e
O or v
S
e
T Break Even Point
n
u where TR=TC
e

Volume (D)