Lesson 2 – Cost, Design

Economics, and Break-even

Analysis
 COST TERMINOLOGIES
Fixed Cost
✓these are costs that are not affected by changes in activity level over a
feasible range of operations for the capacity or capability available.
Typical fixed costs include insurance and taxes on facilities, general
management and administrative salaries, license fees, and interest costs
on borrowed capital. These costs tend to remain constant over a specific
range of operating conditions.
 COST TERMINOLOGIES
Variable Cost
✓these are costs associated with an operation that varies in total with the
quantity of output or other measures of activity level. Costs such as
material and labor used in a product or service are variable costs, because
they vary in total with the number of output units, even though the costs
per unit stay the same.
 COST TERMINOLOGIES
Incremental Cost
✓also termed as incremental revenue, is the additional cost or revenue that
results from increasing the output of a system by one or more units. It is
often associated with “go-no go” decisions that involve a limited change in
output or activity level.
 COST TERMINOLOGIES
Direct Cost
✓ these are costs that can be reasonably measured and allocated to a
specific output or work activity. The labor and material costs directly
associated with a product, service, or construction activity are direct costs.
(e.g, materials needed to make a pair of scissors are direct costs)
 COST TERMINOLOGIES
Indirect Cost
✓these are costs that are difficult to attribute or allocate to a specific
output or work activity. Normally, they are costs allocated through a
selected formula to the outputs or work activities. (e.g, cost of common
tools, general supplies, and equipment maintenance). Overhead consists
of plant operating costs that are not direct labor or direct material cost.
Overhead and indirect costs can be used interchangeably.
 COST TERMINOLOGIES
Standard Cost
these are planned costs per unit of output that are established in advance of actual
production or service delivery. They are developed from anticipated direct labor hours,
materials, and overhead categories. Standard costs play an important role in cost control
and other management functions. Some typical uses are the following:
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
 COST TERMINOLOGIES
Cash Cost
✓a cost that involves payment of cash and results in a cash flow.
✓these costs are estimated from the perspective established for the analysis
and the future expenses incurred for the alternatives being analyzed.
 COST TERMINOLOGIES
Book Cost
✓ a cost that does not involve a cash transaction and is reflected in the
accounting system.
✓also referred to as a noncash cost.
✓ These are costs that do not involve cash payments but rather represent
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 equipment.
 COST TERMINOLOGIES
Sunk Cost
✓ a cost that has occurred in the past and has no relevance to estimate of
future costs and revenues related to an alternative course of action. Thus,
it is common to all alternatives, is not part of the future cash flows, and
can be disregarded in an engineering economic analysis.
✓ these are irretrievable consequences of past decisions and therefore are
irrelevant in the analysis and comparison of alternatives that affect the
future.
 COST TERMINOLOGIES
Opportunity Cost
✓ it is a cost incurred because of the use of limited resources, such that the
opportunity to use those resources to monetary advantage in an alternative
use is foregone.
 COST TERMINOLOGIES
Life-Cycle
✓ it begins with identification of the economic need or want and ends with
retirement and disposal of activities.
✓ it is divided in to two general time periods: acquisition phase and
operation phase.
 COST TERMINOLOGIES
Investment Cost
• is the capital required for most of the activities in the acquisition phase.
This is also known as the capital investment.
Working Capital
• these refers to the funds required for current assets that are needed for
the start-up and support of operational activities.
 COST TERMINOLOGIES
Operation and Maintenance Cost (O&M)
• these costs include many of the recurring annual expense items associated
with the operation phase of the life cycle.

Disposal Cost
• these includes nonrecurring costs of shutting down the operation and the
retirement and disposal of assets at the end of the life cycle
 BREAK-EVEN ANALYSIS
Case 1: Price is Independent of Demand

A. Break-Even point in units B. Break-Even point in dollars

(monetary)
F F
BEPx = BEP$ =
P −V 1−
V
P
Where:
FC = fixed costs
P = selling price
V = variable cost
BREAK-EVEN CHART
EXAMPLE 2.1
BREAK-EVEN ANALYSIS
A new highway is to be built and the contractor has a choice of two sites on which to setup
the asphalt-mixing plant equipment. The contractor estimates that it will cost $1.15 per
cubic yard mile to haul the asphalt-paving material from the mixing plant to the job
location. Factors relating to the two mixing sites are as follows:
Cost Factor Site A Site B
Average hauling distance 6 miles 4.3 miles
Monthly rental of site $1,000 $5,000
Cost to set up and remove equipment $15,000 $25,000
Hauling expense $1.15/yd3-mile $1.15/yd3-mile
Flagperson not required $96/day
 BREAK-EVEN ANALYSIS
Example 2.1 continued
The job requires 50,000 cubic yard of mixed asphalt-paving material It is
estimated that four months or 17 weeks of five working days per week will be
required for the job. Compare the two sites in terms of their fixed, variable and
total costs. Assume that the cost of the return trip is negligible. Which is the
better site? For the selected site, how many cubic yards of paving material does
the contractor have to deliver before starting to make a profit if paid $8.05 per
cubic yard delivered to the job location?
 BREAK-EVEN ANALYSIS
Example 2.2
• An engineering firm measures its output in a standard service hour unit,
which is a function of the personnel grade levels in the professional staff.
The variable cost is $62 per standard service hour. The charge-out rate is
$85.56 per hour. The maximum output if the firm is 160,000 hours per year,
and its fixed costs is $2,024,000 per year. For this firm, what is the break-
even point in standard service hours and in percentage of total capacity?
 Case 2: Demand is a Function of Price

OPTIMAL /
HIGHEST
POINT
BEP211
LOSS

VARIABLE
BEP111 COST

LOSS Source: Sullivan, William G., Elin M. Wicks and James T. Luxhoj. (2006).
ENGINEERING ECONOMY, 13TH ED. Pearson-Prentice Hall. p21-51 FIXED COST

Break-Even Analysis
 BREAK-EVEN ANALYSIS
Example 2.3
• A company produces an electronic timing switch that is used in consumer
and commercial products. The fixed cost is $73,000 per month, and the
variable cost is $83 per unit. The selling price is p = $180 – 0.02D.
a. Determine the optimal volume for this product and confirm that a profit
occurs at this demand.
b. Find the volumes at which breakeven occurs; that is, what is the range
of profitable demand?
 SEATWORK #1
PROBLEM #1
1. A municipal sold waste site for a city must be located at Site A or Site B.
After sorting, some of the solid refuse will be transported to an electric
power plant where it will be used as fuel. Data for the hauling of refuse
from each site to the power plant are shown:

Cost Factor Site A Site B

Average hauling distance 5 miles 4.2 miles
Annual rental fee $5,000 $100,000
Hauling expense $2.50/yd3-mile $2.50/yd3-mile
 SEATWORK #1
PROBLEM #1 continued

• If the power plant will pay $10.00 per cubic yard of sorted solid waste
delivered to the plant, where should the solid waste site be located? Use
the city’s viewpoint and assume that 200,000 cubic yards of refuse will be
hauled to the plant for one year only.
 SEATWORK #1
PROBLEM #2
A large wood products company is negotiating a contract to sell plywood overseas.
The fixed cost that can be allocated to the production of plywood is $900,000 per
month. The variable cost per thousand board feet is $131.50. The price charged will
be determined by p = $600 – 0.05D per thousand board feet.
a. What is the optimal monthly sales volume for this product and calculate the
profit or loss at the optimal value.
b. What is the profitable range of the demand during the month?
 SEATWORK #1
PROBLEM #3
A plant operation has fixed costs of $2,000,000 per year, and its output
capacity is 100,000 electrical appliances per year. The variable cost is $40
per unit, and the product sells for $90 per unit.
a. What is the break-even point in terms of units?
b. What is the break-even point in terms of dollars?
c. How much capacity has been used?
d. If the variable cost is increased to $55, what is the percent reduction
(or increase) to the profit? What is the break-even point in units now?