ISE 2014 CHAPTER 2 - COST CONCEPTS

Fixed/Variable Costs - If costs change appreciably with

fluctuations in business activity, they are “variable.”
Otherwise, they are “fixed.” A widely used cost model is:

Total Costs = Fixed Costs + Variable Costs

Recurring/Nonrecurring Costs - If costs are repetitive and

occur when an organization produces goods or services on
a continuing basis, they are “recurring.” Otherwise they are
“nonrecurring.” Variable costs are recurring since they
repeat with each unit of output.

Direct/Indirect Costs - If costs can be reasonably

measured and allocated to a specific output, they are
“direct.” Otherwise they are “indirect.”
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ISE 2014 CHAPTER 2 - COST CONCEPTS

Overhead Costs - All costs of providing goods or services

other than direct labor and direct material. Indirect costs are
a subset of overhead costs. Fixed overhead relates more to
plant capacity than production volume (variable overhead).
Allocation of overhead to specific outputs may be in
proportion to:
1. Direct labor hours
2. Direct material costs
3. Machine hours

Cash Cost - Involves an actual cash payment.

Book Cost - Reflected only in the accounting system.

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ISE 2014 CHAPTER 2 - COST CONCEPTS

Opportunity Costs - The cost of forgoing the chance to

earn interest (or profit) on investment funds.

Question: “Is it in my best interest to keep my home because

it is all paid for? I’m a retired person living with my
son, and I have rented my former home, valued at
about $185,000, for $400 per month.”

Answer: There is little reason to continue owning your

former home as a rental. To see this, consider the
opportunity cost, i.e., the return you are giving up,
of ownership. The same $185,000 invested in
secure U.S. Treasury bonds at 7% will provide
almost $13,000 in yearly income. This is many
times what is obtained from continual rental.
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ISE 2014 CHAPTER 2 - COST CONCEPTS

Sunk Costs - Past costs that are unrecoverable and are not
relevant for decision making purposes.

Suppose the heating, ventilating and air conditioning

(HVAC) system in your home has just experienced a
major failure. You immediately call the Air Comfort
Company for an estimate to replace your system. Their
price is $4,200 and you gladly sign a contract and write a
check for the required $1,000 down payment. At this
point the weather warms and the urgency for
replacement of your defunct system eases somewhat.
You then get a second estimate for a new HVAC
system. It is $3,000. You call Air Comfort back and they
inform you that the $1,000 down payment is not
refundable! What should you do? Explain.
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ISE 2014 LIFE CYCLE COSTS (LCC)

LCC are a summation of all the costs (and some revenues)

over the entire life span of a structure, or system. All
amounts are expressed in dollars that are time-equivalent
(the subject of Chapter 3).

General Formula:
LCC = Investment Costs
+ Non-Fuel O&M and Repair Costs
+ Replacement Costs
+ Energy Costs
+ Disposal Costs
- Salvage Value (if any)

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 THE GENERAL ECONOMIC ENVIRONMENT

• Consumer goods and services are those products or

services that are directly used by people to satisfy their
wants.
• Producer goods and services are used to produce
consumer goods and services or other producer goods.
• Goods and services may be divided into two types,
necessities and luxuries.
• The General Price-Demand Relationship establishes
that as the selling price per unit increases (decreases)
the demand for that product or service will decrease
(increase).

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 THE GENERAL ECONOMIC ENVIRONMENT

• The relationship between price and demand can be

expressed as a linear function:
a
p = a - bD for 0 ≤ D ≤
b
a-p
D=
b
where
p = price per unit
D = demand for the product or service (# of units)
a = base (maximum) price (intercept on the price axis)
b = slope of the price-Demand line
1/b = amount by which demand increases for each unit
decrease in price

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Scenario I: General Price-Demand Relationship

p = a - bD
Price (p)

Units of Demand (D)

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 THE GENERAL ECONOMIC ENVIRONMENT

• The Total Revenue Function

TR = (price per unit) x (demand) = pD
a
= (a - bD)D = aD - bD 2
for 0 ≤ D ≤
b
where
p = price per unit
D = demand for the product or service (# of units)
a = base (maximum) price (intercept on the price axis)
b = slope of the price-Demand line

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Example - problem 2-8 (p. 60)

Given:
Relationship between price and demand is:
D = 780 - 10p (units/month)
Fixed Cost (CF) = $800/month
Variable Cost per Unit (cv) = $30/unit
Assumptions:
All units produced will be sold
Find: a) D* = number of units produced to maximize profit
b) Maximum profit per month for the product; and
c) Range of profitable demand (production) in
units/month
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#2-8. Solution (part a):

Profit = TR - CT = pD - CF - cvD
solving for p: p = 78 - 0.1D
Profit = (78 - 0.1D)D - 800 - 30D
= 48D - 0.1D2 - 800
Take first derivative and set = 0
dProfit/dD = 48 - 0.2D* = 0
D* = 48/0.2 = 240 units/month

D* = 240 units/month

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#2-8. Solution (part b):

Using equation for profit from part a) and D* = 240,

Profit = 48D - 0.1D2 - 800

Profit =

Maximum Profit =

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#2-8. Solution (part b):

Using equation for profit from part a) and D* = 240,

Profit = 48D - 0.1D2 - 800

Profit = 48(240) - 0.1(240)2 - 800 = $4,960

Maximum Profit = $4,960/month

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#2-8. Solution (part c):

Breakeven points occur when TR = CT (profit = 0)

Profit = 48D - 0.1D2 - 800 = 0
= D2 - 480D + 8000 = 0

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#2-8. Solution (part c) continued:

Using the quadratic equation to solve,

480 ± (480) 2 − 4(1)(8000)
D' =
2(1)
= 240 ± 222.71
D1' = 17.28 or 18 units/month
D2' = 462.71 or 462 units/month

Profitable range of demand: 18 units/mo. ≤ D ≤ 462

units/mo.

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