Engineering Economy

Engineering Economy Engr. Noime B. Fernandez

  Topic 1 – Introduction to Engineering Economy

 Topic 2 – 7 Principles of Engineering Economy

 Topic 3 – Cost Concept and Design

 Topic 4 – Break Even Analysis

 Topic 5 – Present Economy

 Topic 6 – Interest

Engineering Economy Engr. Noime B. Fernandez

 Cost Terminologies

Fixed costs The costs which don’t vary with changing

output. This costs remain constant over a specific
range of operating conditions. It is subject to change
when larger changes in the operating conditions
involved such as plant expansion or shutdown.

Variable costs Costs which depend on the output

produced.
Incremental costs are the additional costs that
result from increasing the output level by one or
more units.

Engineering Economy Engr. Noime B. Fernandez

 Cont.

Recurring Costs are those that are repetitive and

occur when an organization produces similar goods or
services on a continuing basis, e.g., variable cost
and also a periodic fixed cost like office rent.

Nonrecurring Costs are those that are not repetitive,

e.g., construction cost of the manufacturing plant.

Engineering Economy Engr. Noime B. Fernandez

 Cont.

Direct costs that can be attributed to a specific

activity or output, e.g., labor and material costs
directly associated with the a product.

Indirect costs that cannot be attributed to a specific

activity or output. Normally, they are allocated
through a selected formula, such as by proportion,
to the outputs or work activities. Cost of common
tools is an example of the indirect costs.

Engineering Economy Engr. Noime B. Fernandez

 Cont.

Overhead Cost often referred to as overhead or

operating expenses, refer to those expenses
associated with running a business that can’t be
linked to creating or producing a product or service.
They are the expenses the business incurs to stay in
business, regardless of its success level.

Engineering Economy Engr. Noime B. Fernandez

 Cont.

Opportunity cost is the next best alternative foregone.

The opportunity cost is incurred because there are
only limited resources available.

Sunk Costs are those that have occurred in the past

and irretrievable. The original cost of an equipment is
considered to be the sunk cost for a firm in deciding to
replace it or not.

Engineering Economy Engr. Noime B. Fernandez

 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;

Engineering Economy Engr. Noime B. Fernandez

 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;

Engineering Economy Engr. Noime B. Fernandez

 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;

Engineering Economy Engr. Noime B. Fernandez

 Price Function

Price equals some constant value minus some multiple

of the quantity demanded:

PRICE p=a-bD
Where a is the intercept on the price (p)
axis and –b is the slope.

QUANTITY ( OUTPUT )

The relationship between price and demand can be

expressed as a line

Engineering Economy Engr. Noime B. Fernandez

 Cost – Volume Relationship

Total Cost
C
o Variable Cost
s
t Fixed Cost

Volume (D)

Engineering Economy Engr. Noime B. Fernandez

 Total Cost Formula
Total Cost = Total Fixed Cost + Total Variable Cost

TC = CVTOTAL + CFTOTAL
where CVTOTAL = CV x D
= (variable cost/ unit ) (Demand)
thus TC = CV x D + CFTOTAL

REVENUE = Price per unit x Demand

TR = p x D
PROFIT = Total Revenue – Total Cost
TP = TR - TC

Engineering Economy Engr. Noime B. Fernandez

 Revenue Function

TR = p x D
Substituting the price function,
TR = (a–bD) x D => TR = aD- bD2

Plotting the TR function Using Calculus to get the maximum

point,
TR
TRMax = dTR /dD = a –2bD = 0
Rearranging,
D = a / 2b
*demand that maximizes
total revenue, TR

Volume (D)
Engineering Economy Engr. Noime B. Fernandez
 Price equals some constant value minus some
a multiple of the quantity demanded:

p=a-bD

a = Y-axis (quantity) intercept, (price at 0

PRICE amount demanded);
b = slope of the demand function;

D = (a – p) / b

QUANTITY ( OUTPUT )
MR=0 MR = dTR / dD = a –2bD = 0

Total Revenue = p x D
PRICE
= (a – bD) x D
TR = Max =aD – bD2

QUANTITY ( OUTPUT )

Engineering Economy Engr. Noime B. Fernandez

 Cost – Revenue Function

Engineering Economy Engr. Noime B. Fernandez

 Cost, Volume, and Breakeven
Point Relationship
Scenario 1: When the Price is Varying

TC
Cost
or
TR

CF
TR

Quantity /Volume (D)

Engineering Economy Engr. Noime B. Fernandez

 Cost, Volume, and Breakeven
Point Relationship
Scenario 1: When the Price is Varying
Profit = TR – TC
Substituting, Profit = p ∙ D – [CF + CV D]
= (a-bD)∙D - CF - CV D
= aD- bD2 - CF - CV D
= - bD2 + - D [a- CV] – CF
Then using calculus, dProfit/dD = -2bD+(a- CV) = 0
Rearranging
D = (a- CV) / 2b *D that maximizes Profit
*demand level where the profit would be realized
Engineering Economy Engr. Noime B. Fernandez
 Cost, Volume, and Breakeven
Point Relationship
Scenario 1: When the Price is Varying

At Breakeven points, TR = TC
aD- bD2 = CF + CV D
- bD2 + D [a- CV] - CF = 0

Using the Quadratic Formula:

a = -b
b = (a- CV)
c = -CF

Engineering Economy Engr. Noime B. Fernandez

 Cost, Volume, and Breakeven
Point Relationship
Scenario 2: When the price is NOT varying

TR

FIT TC
O
PR
Cost
Break Even Point
or
where TR=TC
TR
S S
LO

Quantity /Volume (D)

Engineering Economy Engr. Noime B. Fernandez

 Cost, Volume, and Breakeven
Point Relationship

Engineering Economy Engr. Noime B. Fernandez

 Cost, Volume, and Breakeven
Point Relationship
Scenario 2: When the price is NOT varying

TOTAL COST
TC = CFTOTAL + (CV x Demand)

REVENUE = Price per unit x Demand

TR = p x D

PROFIT = Total Revenue – Total Cost

TP = TR - TC

Engineering Economy Engr. Noime B. Fernandez

 Cost, Volume, and Breakeven
Point Relationship
Scenario 2: When the price is NOT varying

@ BREAK EVEN POINT, TR = TC

pD = CF + CV D
pD - CV D = CF
D[p - CV] = CF

Therefore D = CF / (p - CV)

Engineering Economy Engr. Noime B. Fernandez

 Practice Problems

1. A company produces and sells a consumer product,

and is able to control the demand for the product by
varying the selling price. The approximate relationship
between price, p, and demand, D, is approximately

2,700
p  38  forD  1
D
Where p is the price per unit in dollars and D is the
discrete demand per month. The company is seeking
to maximize its net profit. The fixed cost is $1,000 per
month and variable cost is $D per unit.

Engineering Economy Engr. Noime B. Fernandez

 Cont.

a) What is the optimal number of units that should be

produced and sold each month?
b) Show that your answer in part (a) maximizes profits.
c) What is the unit price of your answer in part (a)?
d) What are the break even points ? And the range of
profitability?

Engineering Economy Engr. Noime B. Fernandez

 Practice Problems

2. A lash adjuster keeps pressure constant on engine

valves, thereby increasing fuel efficiency in
automobiles engines. The relationship between price
and demand made by the company is given by this
equation: D = (2,000 – p) / .10. What would be the
demand when total revenue is maximized?

Engineering Economy Engr. Noime B. Fernandez

 Practice Problems

3. A cell phone company has a fixed cost of

$1,000,000 per month and a variable cost of $20
per month per subscriber. The company charges
$29.95 per month to its cell phone customer.

a) What is the breakeven point for this company?

b) The company currently has 95,000 subscribers and
proposes to raise its monthly fees to $39.95 to
cover add to add on features. What is the new
breakeven point if the variable cost increases to $25
per customer per month?
c) If 20,000 subscribers will drop their service because
of the monthly fee increase in part (b) will the
company still be profitable?
Engineering Economy Engr. Noime B. Fernandez
 Homework No. 2

1. A company has determine the price and the

monthly demand of its products are related by
the equation
D = where p is the price per unit in dollar and D is the
monthly demand. The associated fixed costs are $1,125
per month and the variable costs are $100/ unit. Use this
information to answer the following:
 
a) What is the optimal number of units that should be
produced and sold each month?
b) Determine the value of D that represents the break-even
point?
Engineering Economy Engr. Noime B. Fernandez
 Homework No. 2

2. A plant operation has fixed costs of $2,000,000 per

year and its output is 100,000 electrical appliances
per year. The variable cost is $40 per unit, and the
product sells for $90 per unit.

a. Construct the economic breakeven chart.

b. Compare annual profit when the plant is operating

at 90% of capacity. Assume that the first 90% of
capacity output is sold at $90 per unit and that the
remaining 10% of the production is sold at $70 per
unit

Engineering Economy Engr. Noime B. Fernandez

 Homework No. 2

3. A company produces and sells a consumer

product and thus far has been able to control the
volume of the product by varying the selling price.
The company is seeking to maximize its net
profit. It has been concluded that the relationship
between price and demand, per month, is
approximately D = 500 – 5p, where p is the price
per unit in dollars. The fixed cost is $1,000 per
month, and the variable cost is $20 per unit.
Obtain the answer mathematically to the
following questions:

Engineering Economy Engr. Noime B. Fernandez

 a. What is the optimal number of units that
should be produced and sold per month?
b. What is the maximum profit per month?
c. What are the breakeven sales quantities
(range of profitable demand volume)?
d. Solve graphically

Engineering Economy Engr. Noime B. Fernandez