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Cost Classification and Design Economics Lecture 2; Chapter 2

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Introduction This course is concerned with making good economic decisions in engineering These decisions often involve non-engineers Managers Accountants Etc. You need to be able to communicate with these people, so you need a common language

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Introduction (cont.) One of the important parts of economic decision is identification of costs Several cost situations occur frequently People have developed terms to describe these You need to know these terms to Understand what others are saying to you Be able to persuade others that you know what you’re doing and therefore should be listened to

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What Do Organizations Produce? Physical output (products) Monetary income (profits)

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What Inputs Do They Use? People’s services (labor) Materials and supplies Raw materials used to make their final products Indirect materials (lubrication oil, etc.) Electric power and other energy inputs Capital (money), which is used to pay for: Land and buildings Producer goods (e.g., tools, equipment) Taxes

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Cost classification (direct and overhead) Most operating organizations’ costs can be summarized under two headings Direct costs Overhead (indirect) costs Of these, overhead costs are often the most complicated and troublesome

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Direct costs Most common direct costs: material & labor These are costs that: Can be easily measured Can be conveniently allocated to a particular category (e.g. a product or service) Examples: Cost of steel used for making bolts Salary of a nurse on cardiac surgery ward

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Overhead (indirect) costs Costs that cannot be traced directly to a particular product/service, because they help support multiple products or services Examples: Depreciation, taxes, insurance, maintenance; electricity; general repairs; common tools Supervisors, engineers, and other administrative/clerical personnel Can also include materials and labor for inspection, testing, etc.

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Standard Costs Representative costs per unit of output established before the good or service is produced or delivered They are developed from anticipated direct labor hours, materials, and overhead categories Play an important role in cost control and other management functions Comparing the actual cost with the standard cost Estimating future manufacturing costs Preparing bids on products or services requested by customers

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Operating expenses The costs of doing business (typically not including depreciation) Includes both direct and indirect costs, but not capital Examples Materials and supplies, wages and salaries, fuel, water, electric power, taxes, insurance

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First Cost The cost or total amount of investment required for getting an activity started: Occurs only once for any given activity Typically assumed to be paid in year 0 Typically used for capital (land, buildings, tools, equipment), not operating expenses

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Fixed Costs Costs that remain constant: Don’t vary with level of production Examples: Depreciation, maintenance, taxes, insurance, lease rentals, interest, sales programs, administrative expenses, research, heat, light, janitorial (doorkeeper) services Fixed costs are only relatively fixed, they may change when: Large changes in usage of resources occur When plant expansion or shutdown is involved

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Variable Costs Costs that vary with activity level: E.g., with number of units produced Typically only direct costs May (or may not) remain constant per unit of product Examples: Materials costs, direct labor, direct electric power

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Average cost This is simply total cost divided by volume Often called “unit cost” Example 1: cost is $250 N, where N is number of units of product made Here cost is purely variable (no fixed cost) Average cost is (250 N)/N = $250 Example 2: cost is $6000 + $100 N Average cost is $100 + 6000/N (decreases with larger N; economy of scale)

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Marginal (Incremental) cost This is the cost change for making one more or one fewer of the product For Example 2 (cost = $6000 + 100 N): N = 100: cost is $16,000 N = 101: cost is $16,100 Here marginal cost is $100, but average cost (at N = 100) is $160 So average and marginal cost may differ!

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Marginal (incremental cost): an example Let’s say: Fixed cost is $50, variable cost is $1 per unit (Cost equation = $50 + $1 N) If we make 10 units: Total cost is $60 Average cost is total cost/number of units: $60/10=$6 per unit Marginal cost is the extra cost (additional cost) if we increase our production by 1 unit: $1 per unit

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Marginal (incremental cost) Marginal cost: It is the correct value to look at in deciding whether to increase production or not We need to compare marginal costs to marginal benefits In our example, marginal cost

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Average Versus Marginal Cost

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Marginal (incremental cost)

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Recurring and Nonrecurring Costs Recurring are the costs that are repetitive All variable costs are recurring, but not all recurring costs have to be variable A fixed cost can be recurring cost, e.g. Office space rental for architectural and engineering service An example of a nonrecurring cost can be the cost of constructing a plant or purchasing a piece of land

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Opportunity cost Opportunity cost is what you have to give up to get something Often expressed in dollar terms; but not always: Opportunity cost of this lecture is 1 hour’s sleep, or more

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Sunk Costs Sunk costs are costs that can’t be recovered Not the same as past costs Sunk costs are generally irrelevant to decision Example: If a firm sinks $1 million on an enterprise software installation, that cost is "sunk" because it was a one-time thing and cannot be recovered once expended. Room painting

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Life-cycle cost This is the total cost for a system, machine, project, etc. during its service life Major subdivisions: Acquisition cost Operation cost Maintenance cost

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Cost-Estimating Methods Accounting Method Engineering Method Statistical Method

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Accounting Method Based on historical data Costs are classified into fixed, variable and semivariable Advantages: simplicity low cost Disadvantages: future might not be like the past

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Engineering Method Depends upon the knowledge of physical relationships (labor-hours, kw of energy, pounds of material) Conjecture about the future is made on the basis of the knowledge on the capacity of equipment, capabilities of people… Useful when historical data is unavailable

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Statistical Method Uses statistical tools (from simple graphs to complex regressions) Objective is to find a functional relationship between changes in costs and factors like output rate The most reliable method when data is available

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Cost, Volume, and Breakeven point Relationship

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Cost, Volume, and Breakeven point Relationship

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Example 2.6

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Solution

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Cost, Volume, and Breakeven point Relationship Scenario 2: demand is independent of price.

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Cost driven design optimization Engineers must maintain a life-cycle (“cradle to grave”) design perspective as they design products and services Ensures engineers consider: Initial investment costs Operation and maintenance expenses Other annual expenses in later years Environmental and social consequences over design life

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Cost-driven Design Optimization Problem Tasks Determine optimal value for a certain alternative’s design variable Example: what velocity of an aircraft minimizes the total annual cost of owning and operating the aircraft Select the best alternative, each with its own unique value for the design variable Example: what insulation thickness is best for a home in Gyumri

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Cost-driven Design Optimization Problem Cost Types Fixed cost(s) Cost(s) that vary directly with the design variable Cost(s) that vary indirectly with the design variable Simplified Format of Cost Model With One Design Variable Cost = aX + (b / X) + k a - is a parameter that represents directly varying cost(s) b - is a parameter that represents indirectly varying cost(s) k - is a parameter that represents the faced cost(s) X - represents the design variable in question (In a particular problem, the parameters a, b and k may actually represent the sum of a group of costs in that category, and the design variable may be raised to some power for either directly or indirectly varying costs.)

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General Approach for Optimizing a Design With Respect to Cost Identify primary cost-driving design variable Write an expression for the cost model in terms of the design variable Set first derivative of cost model with respect to continuous design variable equal to 0. (For discrete design variables, compute cost model for each discrete value over selected range). Solve equation in step 3 for optimum value of continuous design variables For continuous design variables, use the second derivative of the cost model with respect to the design variable to determine whether optimum corresponds to global maximum or minimum.

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Present Economy Studies When alternatives for accomplishing a task are compared for one year or less (I.e., influence of time on money is irrelevant) Rules for Selecting Preferred Alternative Rule 1 – When revenues and other economic benefits are present and vary among alternatives, choose alternative that maximizes overall profitability based on the number of defect-free units of output Rule 2 – When revenues and economic benefits are not present or are constant among alternatives, consider only costs and select alternative that minimizes total cost per defect-free output

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Present Economy Studies Total Cost in Material Selection In many cases, selection of among materials cannot be based solely on costs of materials. Frequently, change in materials affect design, processing, and shipping costs. Alternative Machine Speeds Machines can frequently be operated at different speeds, resulting in different rates of product output. However, this usually results in different frequencies of machine downtime. Such situations lead to present economy studies to determine preferred operating speed.

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Present Economy Studies Make Versus Purchase (Outsourcing) Studies A company may choose to produce an item in house, rather than purchase from a supplier at a price lower than production costs if: direct, indirect or overhead costs are incurred regardless of whether the item is purchased from an outside supplier, and The incremental cost of producing the item in the short run is less than the supplier’s price. The relevant short-run costs of the make versus purchase decisions are the incremental costs incurred and the opportunity costs of resources

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Present Economy Studies Make Versus Purchase (Outsourcing) Studies Opportunity costs may become significant when in-house manufacture of an item causes other production opportunities to be foregone (E.G., insufficient capacity) In the long run, capital investments in additional manufacturing plant and capacity are often feasible alternatives to outsourcing.

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Example 2.13 – Best Operating Speed Lumber put through the planer increases in value by $0.10 per board foot. When the planer is operated at a cutting speed of 5,000 feet per minute, the blades have to be sharpened after 2 hours of operation, and the lumber can be planed at the rate of 1,000 board-feet per hour. When the machine is operated at 6,000 feet per minute, the blades have to be sharpened after 1-1/2 hours of operation, and the rate of planing is 1,200 board-feet per hour. Each time blades are changed, the machine has to be shut down for 15 minutes. The blades, unsharpened, cost $50 per set and can be sharpened 10 times before having to be discarded. Sharpening costs $10 per occurrence. The crew that operates the planer changes and resets the blades. At what speed should the planer be operated? At what speed should it be operated when only one job requiring 6,000 board-feet of planing is considered.