ENGINEERING ECONOMICS

(BPK 30902)

CHAPTER 2:
FUNDAMENTAL COST
CONCEPTS

DR. NOR HAZREN ABDUL HAMID

FAKULTI TEKNOLOGI KEJURUTERAAN
CONTENTS:
Introduction
Cost Terminology
Fixed Costs, Variable Costs and Total Costs
Recurring and Non-recurring Cost
Direct, Indirect and Standard Cost
Cash Cost versus Book Cost
Sunk Cost
Opportunity Cost
Life-cycle Cost
COST TERMINOLOGY
There are a variety of costs to be considered in an EE
analysis.

These costs differ in their frequency of occurrence, relative

magnitude and degree of impact by defining a number of
cost categories and illustrate how they should be treated in
an EE analysis.
FIXED COSTS
Unaffected by changes in activity level over a feasible range
of operations.

Also known as ‘indirect costs’

E.g.
•Insurance and taxes on facilities
•General management and administrative salaries
•License fees
•Interest cost on borrowed capital
•Fixed overhead
VARIABLE COSTS
Associated with an operation that varies in total with the
quantity of output or other measures of activity level.

Also known as ‘direct costs’

E.g.
•The costs of material and labour used in a product or
service
 Direct labour
 Subcontractors
 Indirect costs
 Marketing
 Advertisement
 Legal
INCREMENTAL COSTS
Additional cost (or revenue) that results from increasing the
output of a system by one (or more) units.

E.g.
• Incremental cost per mile for driving
• Incremental cost of producing a barrel of oil
• Incremental cost to the state for educating a student
 TOTAL COSTS
Total Cost (TC) is the sum of Fixed Cost (FC) and
Variable Cost (VC).

TC = FC + VC

whereby: FC do not change as the

production (Q) increases
: VC increase as the production
increases
TOTAL COSTS (CONT.)
In general, the equation for Cost (C) is as follows:
C = F + aQ

whereby F : Fixed Cost

aQ: Variable Cost
a : Average Variable Cost
TOTAL REVENUE
 In general, equation for revenue is as follows:

R = TR - TC

whereby: R = revenue
TR = total revenue
TC = total cost
TOTAL REVENUE (CONT.)

 Breakeven point

TR = TC

whereby TR = total revenue

TC = total cost
EXERCISE 1
Classify each of the following cost items as mostly fixed or variable:

Fixed cost Variable costs

Raw materials
Direct labour
Insurance (building and
equipment)
Supplies
Utilities
Property taxes
Interest on borrowed money
Administrative salaries
Payroll taxes
Sales commission
Rent
Depreciation
EXERCISE 1
Classify each of the following cost items as mostly fixed or variable:

Fixed cost Variable costs

Raw materials 
Direct labour 
Insurance (building and 
equipment)
Supplies 
Utilities  
Property taxes 
Interest on borrowed money 
Administrative salaries 
Payroll taxes  
Sales commission 
Rent 
Depreciation 
 EXERCISE 2
Sharp Manufacturing (SMM) manufactures flat screen TV for global
market. This industry requires total manufacturing cost of
RM500,000 to produce 100 units TV per month. The production can
be increased to 150 units per month with total manufacturing cost of
RM600,000.

• Formulate linear equations for this case.

• Determine the fixed cost (FC) and variable cost (VC)

SOLUTION
TC1 = RM500,000, Q1 = 100 units/month.
TC2 = RM600,000, Q2 = 150 units/month
•Formulate linear equations for this case.
500,000 = FC + 100V ----------- (1)
600,000 = FC + 150V ----------- (2)
•Determine the fixed cost (FC) and variable cost (V)
•From (1); FC = 500000 – 100V
•Substitute (1) into (2); 600000 = 500000 -100V + 150V
V = 100000/50 = RM 2000
•From (1); FC = 500000 – 100(2000)
FC = RM 300,000
EXERCISE 3
Pengeluaran 1 kg kopi memerlukan kos berubah =RM5 dan
Kos tetap sehari = RM300.
a) Terbitkan persamaan linear kos pengeluaran kopi.
b) Kirakan kos pengeluaran bagi 1,000 kg kopi diproses dalam
sehari.

Penyelesaian:
a) Diberi FC = RM300 / hari, VC = RM5 / kg
∴ Jumlah kos, TC = F + VQ = 300 + 5Q
b) Bagi 1,000 kg kopi,
TC = (300/hari)(1 hari) + (5 /kg) x (1000 kg/hari)(1 hari)
= 300 + 5(1000)
= RM 5,300
EXERCISE 4
A contractor has a choice of two sites on which to set up the asphalt-
mixing plant equipment. Factors relating to the two mixing sites are as
follows (production costs at each site are the same):
Cost factor Site A Site B

Average hauling distance 6 miles 4.3 miles

Monthly rental of site RM1,000.00 RM5,000.00

Cost to set up and remove equipment RM15,000.00 RM25,000.00

Hauling expenses (per cubic yard mile) RM1.15/yd3-mile RM1.15/yd3-mile

Flag person Not required RM96/day

The job requires 50,000 cubic yards of mixed-asphalt-paving materials.

It is estimated that four months (17 weeks of five working days per
week) will be required for the job.
A) COMPARE THE TWO SITES IN TERMS OF THEIR FIXED,
VARIABLE AND TOTAL COSTS. WHICH IS THE BETTER
SITE?

Cost Fixed Variable Site A Site B

Rent  RM4,000.00 RM20,000.00
Setup/removal  RM15,000.00 RM25,000.00
Flag person  - RM8,160.00
Hauling  RM345,000.00 RM247,250.00
Total RM364,000.00 RM300,410.00

Site B is better for it has smaller total costs for the job.
B) 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 RM8.05 PER CUBIC YARD
DELIVERED TO THE JOB LOCATION?

Variable cost: 4.3(RM1.15) = RM4.945

Total cost = Total revenue

RM53,160.00 + RM4.945x = RM8.05x
x =17,121 cubic yards delivered
DIRECT COST (VARIABLE COSTS)

 Cost that are reasonable measured and

allocated to a specific work activity

 E.g. Labour & material costs directly associated

with product, service or construction activity
INDIRECT COST
 Costs that are difficult to attribute or allocate to a specific
output or work activity (also overhead or burden).

 Normally, they are costs allocated through a selected

formula. E.g.: cost of common tools, general supplies and
equipment maintenance in a plant.

 Overhead consists of plant operating costs that are not

direct labour or direct material costs. E.g.: electricity
general repairs, property taxes

 The terms indirect cost and overhead are used

interchangeably.
STANDARD COST
 Planned cost per unit of output that are established in advance
of actual production or service delivery.

 Developed from anticipated direct labour hours, materials, and

overhead categories (with their established costs per unit)

 Play an important role in cost control and other management

function.
STANDARD COST (CONT.)
 Examples:

1. Estimating future manufacturing goals;

2. Measuring operating performance by comparing actual cost
per unit with the standard unit cost; and
3. Preparing bids on products or services requested by
customers.
CASH EXPENSE VERSUS NON-CASH
EXPENSE
CASH EXPENSE BOOK COST (N0N-CASH EXPENSE)
Involves payment of cash Does not involve a cash transaction and
is reflected in the accounting system
(income statement)
Results in a cash flow Do not involve cash payments but
rather represent the recovery of past
expenditures over a fixed a period of
time. E.g. depreciation

In EE analysis, only those costs that are cash flows or potential cash
flows from the defined perspective for the analysis need to be
considered.
SUNK COST
 Occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course
of action.

 Is common to all alternatives, is not part of the future

(prospective) cash flow and can be disregarded in an EE
analysis.
SUNK COST (CONT.)
 Example:
 A firm is considering the replacement of a piece of
equipment. It originally cost RM50,000, is presently
shown on the company records with a value of RM20,000,
and can be sold for an estimated RM5,000.
 Therefore, the sunk cost is: (RM20,000 – RM5,000) =
RM15,000.
OPPORTUNITY COST
 Is 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.

 Thus, it is the cost of the best rejected (i.e. foregone)

opportunity and is often hidden or implied.
OPPORTUNITY COST (CONT.)

 Example:
 A firm is considering the replacement of a piece of
equipment. It originally cost RM50,000, is presently
shown on the company records with a value of
RM20,000, and can be sold for an estimated RM5,000.
 The present investment in the equipment should be
considered as RM5,000, because, by keeping the
equipment, the firm is giving up the opportunity to
obtain RM5,000 from its disposal.
RECURRING COSTS
Periodic

 Annual expenses items for direct & indirect cost

associated with five primary resources

 E.g. people, machines, materials, energy &

information - major part expenses
NON-RECURRING COSTS
One time cost

 Expenses for shutting down operation & retirement

& disposal of assets

 E.g. Personal, materials, transportation etc.

LIFE-CYCLE COST
 Refers to a summation of all the costs related to a product,
structure, system or service during its life span.

 The life cycle begins with identification of the economic

need or want (the requirement) and ends with retirement
and disposal activities.

 It is a time horizon that must be defined in the context of

the specific situation and the end of the life cycle may be
projected on a functional or an economic basis.

 Is divided into two general time periods: acquisition and

operational phase
 LIFE-CYCLE COST (CONT.)

High Potential for

life-cycle cost
saving

Cumulative
life-cycle
cost

Cost Cumulative
(RM) commited
life-cycle
cost

Time
0
Needs Conceptual Details Production or
Operation or Retirement &
assessment: (preliminary) design construction
customer use: disposal
defination of design: production or
maintenance
requirement advanced construction
& support
development planning:
prototype facility &
testing resources
accquisition

Acquisition phase Operation phase

LIFE-CYCLE COST (CONT.)
LIFE-CYCLE COST –
THE ACQUISITION PHASE
 1) Analysis on the economic need or want
- To make explicit the requirement for the product, structure, system,
or service.
- With the requirement explicitly defined, the other activities in the
acquisition phase can proceed in a logical sequence
 2) Conceptual design activities
- Translate the defined technical and operational requirements into
a preferred preliminary design.
- Activities: development of the feasible alternatives; advanced
development; prototype testing.
 3) Detailed design and planning for production/construction
- Activities necessary to prepare, acquire, and make ready for
operation the facilities and other resources needed.

EE studies are an essential part of design process to analyze & compare

alternatives & to assist in determine the final details design
LIFE-CYCLE COST –
THE OPERATION PHASE
 The production, delivery, or construction of the end
item(s) or service and their operation or customer use
would occur

 Ends with retirement from active operation or use and,

often, disposal of the physical assets involved.

 The priorities if EE in this phase:

 Achieving efficient and effective support to operations
 Determining whether (and when) replacement of assets
should occur
 Projecting the timing of retirement and disposal
activities
LIFE-CYCLE COST –
CATEGORIES
 Investment cost
 Capital required for most activities in the acquisition
phase
 E.g. Single expenditure & series of expenditure
 a.k.a. capital investment

 Working capital
 Funds required for the start-up & support of operational
activities
 E.g. Material for product/ spare part for maintenance/ cash
for salaries etc
LIFE-CYCLE COST –
CATEGORIES (CONT.)
 Operation and maintenance cost (O&M)
 Includes many of the recurring annual expenses items
associated with operation phase of LC
 Direct & indirect cost of operation associated with 5
primary resources (people/machines, materials/ energy/
information

 Disposal cost
 Includes those non-recurring costs of shutting down the
operation & the retirement & disposal of assets at of LC
THANK YOU…
TUTORIAL CHAPTER 2
An entrepreneur named DK was considering the money-making potential
of chartering a bus to take the people from his hometown to an event in a
larger city. DK planned to provide transportation, tickets to the event and
refreshment on the bus for his customer. He gathered data and
categorized the predicted expenses as either fixed or variable.

DK’s Fixed Costs DK’s Variable Costs

Bus rental $80 Event ticket $12.50 per
person
Gas expense 75 Refreshment 7.50 per person
s
Other fuels 20
Bus driver 50

Develop an expression of DK’s total fixed and variable costs for

chartering trip.
SOLUTION
DK’s fixed cots will be incurred regardless of how many people
sign up for the trip (even if only one person signs up!!)

Total fixed costs = 80 + 70 + 20 + 50 = $225

DK’s variable costs depend on how many people sign up for the
charter, which the level of activity

Total variable costs = 12.50 + 7.50 = $20 per person

So, DK’s total cost equation :

TC = FC + VC
TC = 225 + 20 * (number of people on the trip)
TC = 225 + 20x
CONTINUE..
Evaluate the potential to make money from this chartered bus trip.
If DK believe that he could attract 30 people at a charter ticket
price of $35.
Total revenue = charter ticket price * number of people on the trip
= 35x

Total profit = total revenue – total costs

= 35x – (225 + 20x)
= 15x – 225

If x = 30,
Total profit = $225.
A distributor of electric pumps must decide what to do with a “lot” of old
electric pumps purchased 3 years ago. Soon after the distributor purchased
the lot, technology advances made the old pumps less desirable to
customers. The pumps are becoming more obsolescent as they sit in
inventory. The pricing manager has the following information.

Distributor’s purchase price 3 years ago $ 7,000

Distributor’s storage costs to date 1,000
Distributor’s list price 3 years ago 9,500
Current list price of the same number of new pumps 12,000
Amount offered for the old pumps from a buyer 2 years ago 5,000
Current price the lot of old pumps would bring 3,000

Looking at the data, the pricing manager has concluded that the price
should be set at $8000. This is the money that the firm has “tied up” in the
lot of old pumps ($7000 purchase and $1000 storage), and it was reasoned
that the company should at least recover this cost. Furthermore, the pricing
manager has argued than an $8000 price would be $1500 less than the list
price from the 3 years ago, and it would be $4000 less than what a lot of
new pump would cost ($12,000 - $8000). What should be your advice on
price?
SOLUTION
Distributor’s purchase price 3 years ago:
This is a sunk cost that should not be considered in setting the price
today.
Distributor’s storage costs to date:
The storage costs for keeping the pumps in inventory are sunk costs; that
is; they have been paid. Hence they should not influence the pricing
decision.
Distributor’s list price 3 years ago:
If there have been no willing buyer in the past 3 years at this price, it is
unlikely that a buyer will emerge in the future. This past list price should
have no influence on the current pricing decision.
Amount offered from a buyer 2 years ago:
This is a forgone opportunity. At the time of the offer, the company chose
to keep the lot and thus the $500 offered become an opportunity cost for
keeping the pumps. This amount should not influence the current pricing
decision.
Current price the lot could bring:
The price a willing buyer in the marketplace offers is called the
asset’s market value. The lot of old pumps in question is believed
to have a current market value of $3000.

From this analysis, it is easy to see the flaw in the pricing

manager’s reasoning. In an engineering economist analysis we
deal only with today’s and prospective future opportunities. It is
impossible to go back in time change decisions that have been
made. Thus, the pricing manager should recommend to the
distributor that the price be set at the current value that buyer
assign to the item: $3000.