Lecture 2

Cost concepts and engineering economic

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analysis (Part 2 )

Chapter 2
These slides prepared by Prof. Osama, Dr. Essam and modified by Eng.
Mohammed Ismaeel Shekfa

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Objectives
1. Describe some of the basic cost terminology
and concepts widely used in engineering

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economic analysis.

2. Illustrate the way they are used in engineering

economic analysis and decision making

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Basic Terminology
• Consumer goods and services are directly

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used by people to satisfy their needs.
Examples are:

• Food
• Clothing
• Homes
• Cars
• Haircuts
• Medical services 3
Basic Terminology
• Producer goods and services are used to

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produce consumer goods and services.
Examples are:

• Machine tools
• Factory buildings
• Buses
• Farm machinery

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Basic Terminology
• The relationship between producer goods and

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services and people is less direct than relation
with consumer goods. Therefore the demand
for producer goods may greatly precede or lag
behind the demand for consumer goods

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Basic Terminology
• Utility of goods and services is their power to

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satisfy, directly or indirectly the human wants
and needs

• Utility is measured in terms of value which is

reflected by the price of the product or service

• Much of our business activities, including

engineering, focus on increasing the utility value
of materials or products by changing their from
or location. Example are: Iron ore processed and
manufactured to various steel products and snow
mountains in melted form to desert residential 6
areas
Basic Terminology
• Goods and services may be divided into two

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types

Necessities Luxuries

• What one person considers a necessity may be

considered as a luxury by another 7
Basic Terminology
• Most principles of engineering economy are applicable for situations in

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which perfect competition exists.

• Perfect competition exists in a situation in which any given product is

supplied by a large number of vendors and there is no restriction on
additional suppliers entering the market.

• Perfect competition may never occur in actual practice where some

degree of limitation is imposed upon the actions of buyers or sellers or
both.

• General economic laws are easier to be formulated under conditions of

assumed perfect competition.
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• Perfect competition will be always assumed unless otherwise stated.

 Basic Terminology
Buyer is at the
Unique product or
complete mercy of

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service is only
the supplier in terms
available by single
of availability and
supplier
price

Found because: 1‐
Substitutes 2‐
Opposite of perfect Governmental
competition regulations prohibit
monopoly if they are
unduly restrictive
Monopoly
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General Formula
• Pr is the profit (is the money a

Pr  RT  CT business makes after accounting for

all the expenses)

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• Rt is the total Revenue can get from
selling demands

• Ct is the total cost from

RT  p  D • P represent selling price per unit

• D is the Demand or production

required

• CF is the fixed cost

CT  C F  CV • Cv is the variable cost 10
General Formula
Two important Demands (volume) must be known

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D * is the optimum volume means demand that cause
max imum profit or revenue. Mathematically by
first derivative  0

D \ Breakeven po int that show range of the profit

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area. Mathematically set Pr  0
Price – Demand relationship
(Scenario 1)
• In some scenario the price is

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dependent with the demand “not
always constant” it can be
represented by different equations

• Price equals some constant value

minus multiple of the demand

p  a b D
(0  D  a / b, a  0, b  0)
Where: p is the price per demand
• D is the demand
• a is the intercept on the price
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axis
• b is the slope of the demand
function
Price – Demand relationship
(Scenario 1)

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• Total Revenue
Total Revenue
Function

RT  p  D
RT  (a  b  D)  D
RT  a  D  b  D 2

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Price – Demand relationship
(Scenario 1) • To find maximum
Revenue Rt max we

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need to find optimum
volume D* for the
Revenue by the first
derivative then2 = 0
RT  a  D  b  D
RT
D  a  2b  D
D*  a
2b
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subs.
2
RT max  a  a b a
2b 2b
 Price – Demand relationship
(Scenario 1) • To draw the profit area with
scenario 1 “price is
represented by linear

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• Profit will equal: equation”:
Pr  a  D  b  D 2
 C F  cV  D Pr  R T  C T
• Also The RT
RT  a  D  b  D 2
• Knowing that variable cost is
depend on the demand while
fixed not that make the CT will be
equal

CT  C F  cV  D
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cV :Variable cos t per unit
Price – Demand relationship
(Scenario 1)

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Price – Demand relationship
(Scenario 1)

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• To Find Maximum Profit, D* must be calculated
by:
Pr  a  D  b  D 2
 C F  cV  D
 Pr
 D  a  2  b  D  cV  0
a  cV
D*  .......... .......( 1 )
2b
To Check Optimum Demand
1) a  c V  0

2)  2
Pr  0
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D 2
 Price – Demand relationship
(Scenario 1)
• To find range of the profit area \
must be

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D
calculates as:

Pr  a  D  b  D 2
 C F  cV  D  0
( a  c V ) D  bD 2
 CF  0
 bD 2
 ( a  cV ) D  C F  0
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 ( a  cV )  ( a  c V ) 2  4 (  b )(  C F )
D \
1, 2 
2(b)
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Price – Demand relationship
(Scenario 2) • In this scenario the price
is independent with the

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demand means constant
value in all time
RT Vs D

• Which make the RT as

RT  p  D

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 Price – Demand relationship
(Scenario 2)
• In this scenario there is no D* because the

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Revenue will increase as the demand increase
• Only D \ will be calculated as
Pr  p  D  C F  c V  D  0
CF
D \
1 
( p  cV )

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Present Economy Study
• The present economy studies is the engineering
economic analysis involving comparing between

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different alternatives for accomplishing a specific task
,over one year or less, and the influence of time on
money can be ignored.

• The following two rules are used to select the

preferred alternative when defect free output (yield) is
variable (Rule 1) or constant (Rule 2). Other criteria
of acceptability such as compliance with
environmental regulations must also be satisfied. 24
Present Economy Study
• Selection between any economy study depends on

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• Rule used
• Time required and mainly less than a year

• Finding common measure units to compare between

alternatives

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Rule 1

• When revenues and other economic benefits are

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present and vary among alternatives, choose the
alternative that maximizes overall profitability based
on the number of defect-free units of a product or
service produced.

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Rule 2
• When revenues and other economic benefits are not
present or are constant among all alternatives,

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consider only the costs and select the alternative that
minimizes total cost per defect-free unit of a product
or service produced.

• Total cost in material selection:

• Economic selection among materials cannot be based solely on

the cost of materials. Frequently, a change in materials will affect 27
the design and processing costs, and shipping cost may also be
altered.
Total cost in material selection

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Alternative Machine Speeds
• Machines can be operated at various machine speeds,
resulting indifferent outputs. This, however, results

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in variations in the frequencies of machine down
time to maintain machines and tools in a good
productive condition.

• This leads to present economy studies to select the

preferred operating speed.

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Making versus purchasing
(outsourcing) studies
• In the short run, one year or less, a company may seek
producing an item in house despite that this item can be
purchased (outsourced) for less than the company’s standard

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production cost.

• This could occur if:

• Direct, indirect, and overhead costs are incurred regardless of

whether the item is purchased from an outside supplier.
• The incremental cost of producing an item in the short run is less
than the supplier’s price.

• Thus standard costs may not be useful in make versus

purchase studies and can lead to uneconomical decisions.
• In the long run capital investments in additional 30
manufacturing plant are feasible alternative to outsourcing.
Trade-offs in energy efficiency
studies
• Energy efficiency affects the annual expense of operating an
electrical device such as a pump or motor.

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• For a given power output the input power to the electrical
device, and consequently the cost, is lass for devices having a
higher efficiency.

• Thus, despite that electrical devices having higher efficiency

are more expensive, their electrical power expenses are less.

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