Lecture 2

Cost concepts and engineering economic

1/11/2021
analysis (Part 1)

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

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

1/11/2021
economic analysis.

2. Illustrate the way they are used in engineering

economic analysis and decision making

2
Basic Terminology
• Balance of what is technically feasible and what

1/11/2021
is economically acceptable.

• Cost concepts are needed to be integrated with

the principles of engineering economy and design
consideration.

• The most difficult part of an engineering

economy study is the estimation of costs,
revenues, useful lives and residual values as
pertaining to the design of alternatives being
analyzed. 3
Basic Terminology
Cost estimating

• Cost estimating term is used to describe the process by which the present
and future cost consequences of engineering designs are forecast.

1/11/2021
• Accurate cost estimations for new projects are difficult as most of the new
projects are unique.

• Cost estimating efforts require the active participation of engineering

designers and personnel from manufacturing, marketing, finance and top
management.

• Results of cost estimating are used for:

1- Setting a selling price for quoting, bidding or evaluating contracts.
2- Whether a proposed product can be made and marketed at a profit.
3- Estimating the capital needed for process changes or improvements. 4
4- Justifying (establishing bench marks) for productivity improvement
programs.
Cost Estimation
• Two approaches can be used in cost estimation:
• The top- down approach

1/11/2021
• The bottom-up approach.

• In the top- down approach, historical data from similar

engineering project are adjusted to estimate the cost. This
approach is best used early in the estimation process when
alternatives are still being developed.

• In the bottom- up approach a project is broken down into

small manageable units and sum their estimated costs. This
5
approach is used at a later stage when a product or service
has been defined.
Type of Costs
• Fixed, variable, & incremental costs
• Recurring & nonrecurring costs

1/11/2021
• Direct, indirect, & overhead costs
• Cash cost vs book cost
• Sunk costs & opportunity costs
• Life-cycle costs

6
Fixed Cost
• Fixed costs are those unaffected by changes in activity level for the
available capability. Typical examples include:

1/11/2021
• insurance and taxes on facilities,
• salaries of administration,
• license fees and interest costs on borrowed capital.

• Fixed costs are affected when large changes in usage of resources

occur

• Fixed costs tend to remain constant over a specific range of

operation conditions
• When large changes in usage of resources occur, or when plant
expansion or shutdown is involved fixed costs will be affected 7
Variable Cost
• Variable costs are those associated with the quantity
of production as the cost of:

1/11/2021
• Materials

• Labor used in production.

8
Incremental Cost
• An incremental cost (or revenue) is the additional cost
resulting from increasing the output of a system by one unit.
Examples are

1/11/2021
• “incremental cost for producing a barrel of oil”. The
incremental cost is difficult to determine.

• Break even point when the Total cost=total revenue

9
Example 2-1:

• In connection with surfacing a new highway, a contractor has a

choice of 2 sites on which to set up the asphalt mixing plant
equipment. The contractor estimates that it will cost $1.15 per

1/11/2021
cubic yard per mile (yd3 –mile) to haul 50,000 yd3 of asphalt
paving material from the mixing plant to the job location. It is
estimated that 4 months (17 weeks of 5 working days/week)
will be required for the job. Assume that the cost of the return
trip is negligible and that production costs at each site are the
same. Which is the better site? For the selected site, how many
yd3 of paving material does the contractor have to deliver
before starting to make a profit if paid $8.05 per yd3 delivered
to the job location? Factors relating to the 2 mixing sites are as 10
follows (production costs at each site are the same):
 1/11/2021
11
Solution

1/11/2021
12
Solution Part 2

• The contractor will begin to make profit at the point where total revenue
equals total cost as a function of the cubic yards of asphalt pavement mix
delivered. Based on Site B, we have:

1/11/2021
• First Variable cost 4.3($1.15) = $4.945 in variable cost per yd3 delivered
• Fixed cost remain constant = $53160 including (rent, flag person, cost setup
and removal)
• To start gaining profit after the break even point when the
• Total cost = total revenue

• $53,160 + $4.945x = $8.05x

• x = 17,121 yd3 delivered 13

 Basic cost terminology and concepts
(continued)
Recurring and nonrecurring costs

• Recurring costs are those that are repetitive and occur when an organization
produces similar goods on a continuing basis.

1/11/2021
• Variable costs are recurring costs as they repeat with each unit of output. Another
example is a fixed cost that is paid on a repeatable basis, like the rent of a space.

• Nonrecurring costs are those which are not repetitive. It is over short period of time.

• Typical examples for nonrecurring costs are the costs involved in developing or
establishing a capability for production or the cost of purchase of a real estate or the
cost of construction of a plant.

14
 Basic cost terminology and concepts
(continued)
Direct and indirect costs

• Direct costs are costs that can be allocated to a specific output or work activity.

1/11/2021
Examples are labor cost and material cost for equipment maintenance.

• Indirect costs are costs that are difficult to allocate to a specific output or work
activity. Typical examples are the cost of common tools, general supplies and
equipment maintenance.

• Overhead consists of plant operating costs that are not direct labor or indirect
material. Overhead costs are associated with a certain level of production.
Overhead costs include electricity, general repairs, and property taxes.

15
• direct costs + overhead costs + administrative and selling expenses + profit =
unit selling price for a product.
Basic cost terminology and concepts
(continued)

1/11/2021
16
 Basic cost terminology and concepts
(continued)
Standard costs

• Standard costs are the cost per unit of output established in advance of actual
production or service delivery.

1/11/2021
• Typical uses of standard costs are:
1- Estimating future manufacturing costs.
2- Measuring operating performance by comparing actual cost per unit with
the standard unit cost.
3- Preparing bids on products or services requested by customers.
4- Establishing the value of work in process and finished inventories.

17
 Basic cost terminology and concepts
(continued)
Cash cost versus book cost

• Cash cost is the cost that involves payment of cash and results in cash flow.

1/11/2021
cash costs are important in engineering economic analysis as they represent the
future expenses incurred for the alternatives being analyzed.

• Non-cash cost or book cost, in accounting, does not involve cash payment. It
represents the recovery of past expenditures over a fixed period of time.

• The most common example of book cost is the depreciation charged for the use
of assets such as plant and equipment.

• Depreciation is not a cash flow and is important in the analysis only as it affects
income taxes which are cash flow.
18
 Basic cost terminology and concepts
(continued)

Sunk cost

1/11/2021
• Sunk costs result from past decisions and therefore are irrelevant in the
analysis and comparison of alternatives that affect the future. Example is the
down payment paid ( if it is not refundable) for a product.

Opportunity cost

• Is the cost of the best rejected opportunity, due to the available limited
resources. Example is the money a company can earn by hiring a space but this
is rejected as the space is needed for a company project.

19
 Basic cost terminology and
concepts (continued)
Life‐ cycle cost

1/11/2021
• Refers to the summation of all costs,
both recurring and nonrecurring, Cumulative committed
life cycle cost
related to a product, system, or service Potential for life cycle
Cost saving
during its life span.
• The life cycle may be divided Cost Cumulative life
Cycle cost
into two general time periods;
the acquisition phase and
the operation phase. Time
Preliminary Operation
• Each of these phases is further Needs
assessment,
design,
advanced
Detailed
design,
Production
Or
Customer
Retirement
And
Production
Definition of disposal
subdivided into interrelated requirements
development,
prototype
planning,
Facility
use,
Maintenance
testing acquisition and support
but different activity periods. Acquisition Phase Operation Phase
Phases of the life cycle and their relative cost
20
Basic cost terminology and concepts
(continued)

1/11/2021
21
LCC

1/11/2021
Life Cycle Cost = initial (projected) capital costs + projected life‐time operating costs 22
+ projected life‐time maintenance costs + projected capital rehabilitation costs +
projected disposal costs ‐ projected residual value.
 Basic cost terminology and concepts
(continued)

Life- cycle cost

1/11/2021
• During operation phase:

1- achieving efficient and effective support operations.

2- deciding whether replacement of assets should occur.

3- Projecting and timing for retirements.

23
 Basic cost terminology and concepts
(continued)

• The greatest potential for achieving life-cycle cost savings is early in the
acquisition phase (This is shown by the red curve).

1/11/2021
• Effective engineering design and sound economic analysis during the
acquisition phase result in maximizing potential savings.

• One aspect of cost effective

engineering design is the
minimizing of the impact of
design changes during the
Cost
Costs of design changes are significant.
They multiply by 10 with each step
10000

steps in the life cycle. 1000

100

10

Needs
Assessment
Preliminary
Design
Detailed
Design
Production Operation 24
Life cycle step
 Basic cost terminology and concepts
(continued)

1/11/2021
• The following defines the categories of the basic life
cycle cost:

1- Investment cost: Is the capital needed for most of the

activities in the acquisition phase (capital investment).

25
Working Capital
• Working capital: refers to
the funds needed for current

1/11/2021
assets, other than fixed
assets
• such as equipment and
facilities, that are needed for
the start up and support of
operational activities.

• Examples are materials in the

inventory, spare parts, tools and
trained personnel needed for
maintenance and salaries for 26
employees.
Basic cost terminology and concepts
(continued)

3- Operation and maintenance cost: includes many of the

recurring annual expenses associated with the operation

1/11/2021
phase of the life cycle. This include the cost of the five
primary resource areas; people, machines, materials,
energy, and information.

4- Disposal cost: includes nonrecurring costs of shutting

down the operation and the disposal of assets at the end
of the life cycle.

27