Engineering Economy

1. Engineering Economy Chapter 2: Cost Concepts and Design Economics By Ir. Ts. Dr. Nasrul Amri bin Mohd Amin Universiti Malaysia Perlis

2. The objective in this chapter is to describe basic cost terminology.

3. Fixed cost: unaffected by changes in activity level Variable cost: vary in total with the quantity of output (or similar measure of activity) Incremental cost: additional cost resulting from increasing output of a system by one (or more) units Costs can be categorized in several different ways.

4. Fixed costs are those unaffected 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. When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected. FIXED, VARIABLE, AND INCREMENTAL COSTS

5. Variable costs are those associated with an operation that vary in total with the quantity of output or other measures of activity level. Example of variable costs include : costs of material and labor used in a product or service, because they vary in total with the number of output units -- even though costs per unit remain the same. FIXED, VARIABLE AND INCREMENTAL COSTS

6. Example 1 An entrepreneur named DK was considering the money making potential of chartering a bus to take people from his hometown to an event in a larger city. DK planned to provide transportation, tickets to the event, and refreshments on the bus for those who signed up. He gathered data and categorized these expenses as either fixed or variable: Fixed, Variable and Total Costs

7. Fixed, Variable and Total Costs

8. Example 2

11. An incremental cost is the difference between the costs of two alternatives. Example 4 Choose between alternative models A and B. What incremental costs occur with model B? Incremental Costs

12. Direct: can be measured and allocated to a specific work activity Indirect: difficult to attribute or allocate to a specific output or work activity (also overhead or burden) Standard cost: cost per unit of output, established in advance of production or service delivery More ways to categorize costs

13. Cash cost • A cost that involves payment of cash • A cash cost requires the cash transaction of dollars "out of one person's pocket" into "the pocket of someone else." E.g: When you buy dinner for your friends or make your monthly automobile payment you are incurring a cash cost or cash flow. Cash costs and cash flows are the basis for engineering economic analysis.

14. 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; it is important as depreciation affect income taxes, and subsequently affects the cash flow as well CASH COST VERSUS BOOK COST

15. A sunk cost is money already spent as a result of a past decision. Sunk costs should be disregarded in our engineering economic analysis because current decisions cannot change the past. SUNK COST AND OPPORTUNITY COST

16. For example, dollars spent last year to purchase new production machinery is money that is sunk: the money allocated to purchase the production machinery has already been spent-there is nothing that can be done now to change that action. SUNK COST AND OPPORTUNITY COST

17. Opportunity cost: the monetary advantage foregone due to limited resources. The cost of the best rejected opportunity. Life-cycle cost: the summation of all costs related to a product, structure, system, or service during its life span. More useful cost terminology

18. Things to Ponder!!!! Unlike other types of cost, opportunity cost does not require the payment of cash or its equivalent. It is a potential benefit or income that is given up as a result of selecting an alternative over another. Almost every alternative has an opportunity cost. It is not entered in the accounting records but must be considered while making decisions.

19. Pop Quiz • You have a job in a company that pays you $25,000 per year. For a better future, you want to get a Master’s degree but cannot continue your job while studying. If you decide to give up your job and return to school to earn a Master’s degree, you would not receive $25,000. What would be your opportunity cost?

20. Answer… • $ 25,000

21. LIFE-CYCLE COST • Life-cycle costing refers to the concept of designing products, goods, and services with a full and explicit recognition of the associated costs over the various phases of their life cycles. • Two key concepts in life-cycle costing are that the later design changes are made, the higher the costs, and that decisions made early in the life cycle tend to "lock in" costs that are incurred later. • Figure 2-2 illustrates how costs are committed early in the product life cycle-nearly 70-90% of all costs are set during the design phases. At the same time, as the figure shows, only 10-30% of cumulative life-cycle costs have been spent.

22. Phases of the Life Cycle and Their Relative Cost

23. LIFE-CYCLE COST • Several basic life cycle cost categories • Investment cost – capital required for most activities in the acquisition phase. also known as Capital investment 2) Working capital – funds to required for current assets. Tools, spare part, salary 3) Operation and Maintenance cost-recurring annual expense item associated with the operation phase of life cycle 4) Disposal cost – non-recurring costs of shutting down the operation and disposal of assets at the end of life cycle. E.g- cleaning site

24. Importance of life-cycle concept • One purpose of the life-cycle concept is to make explicit the interrelated effects of costs over the total life span for a product. An objective of the design process is to minimize the life-cycle cost – while meeting other performance requirements-by making the right trade-offs between prospective costs during the acquisition phase and those during the operation phase.

25. Example 3