Engineering Economy

Chapter 2: Cost Concepts and Design

Economics

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Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 The objective of Chapter 2 is to
analyze short-term alternatives when
the time value of money is not a
factor.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Costs can be categorized in several
different ways.
• Variable cost: vary in • Fixed cost: unaffected
total with the quantity of by changes in activity
output (or similar level over a feasible
measure of activity range of operations.
level)
•

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Total Cost
• Total cost = Fixed Cost + Variable cost

Slope = variable cost per unit

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Overhead cost

• Costs that are difficult to allocate to a specific

output or work activity.

Example: electricity

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Common cost terminology.
• Cash cost: a cost that involves a payment of cash.

• Non-cash cost (Book cost): a cost that does not

involve a cash transaction but is reflected in the
accounting system.

• Sunk cost: a cost that has occurred in the past and

has no relevance to estimates of future costs and
revenues related to an alternative course of action.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 More common cost terminology

• Opportunity cost: the monetary advantage

foregone due to limited resources. The cost of the
best rejected opportunity.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Exercise: Variable, Fixed, Sunk or Opportunity
Cost?
1- Wood used in a table ($100 per table)
2- Labor cost to assemble a table ($ 40 per table)
3- Salary of the factory supervisor ($ 38,000 per year)
4- Salary of the company president ($100,000 per year)
5- Commission paid to salespersons ($30 per table sold)
6- Rental income forgone on factory space
7- Advertising expense ($ 250,000 per year)
8- Interest costs on borrowed loan (2%)
9- Property taxes
10- Insurance on building

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Example 2-1: Fixed and Variable Costs
In connection with surfacing a new highway, a contractor has a choice of two sites on
which to set up the asphalt-mixing plant equipment. The contractor estimates that it
will cost $2.75 per cubic yard mile (yd3-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 (production costs at each site are the same):
Cost Factor Site A Site B
Average hauling distance 4 miles 3 miles
Monthly rental of site $2,000 $7,000
Cost to set up and remove $15,000 $50,000
equipment
Hauling expense $2.75/yd3-mile $2.75/yd3-mile
Flagperson Not required $150/day

The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated

that four months (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?
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Example 2-1: Solution

Cost Site A Site B

Rent (fixed) 2000*4= 8000 7000*4=28000
Setup/Removal 15,000 50,000
(fixed)
Flagperson 0 150*17*5= 12750
(fixed)
Hauling 2.75*50000*4= 550,000 2.75*50000*3= 412500
Total 573,000 503,250

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Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Life-Cycle-Cost
• Life-cycle cost: the summation of all costs related
to a product, structure, system, or service during
its life span.
Operation and
Maintenance
Cost

Investment Working Disposal

Cost Capital Cost
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Life-Cycle-Cost is divided into two general time
periods:
1. The Acquisition phase
a) Needs assessment (requirements)
b) Conceptual or preliminary design (investment cost: the capital
required for most of the activities, e.g. acquiring specific
equipment)
c) Detailed Design (production planning, resource acquisition)
(working capital: funds required for current assets that are needed
for start-up and support operational activity)

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Life-Cycle-Cost is divided into two general time
periods:
2. The Operation phase
a) Production or construction (O&M cost: annual expenses
associated with the operation)
b) Customer use, maintenance and support (O&M cost)
c) Retirement and disposal (disposal cost: nonrecurring costs of
shutting down the operation and disposal of assets at the end of
the life cycle)

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 The General Economic Environment
• Consumer and Producer Goods and Services

• Necessities and Luxuries

• Measures of Economic Worth

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Market Types
1. Perfect Competition Market:
so many buyers and sellers, occurs when any given product is
supplied by a large number of vendors and there is non restriction on
additional suppliers entering the market.

Characteristics:
I. The goods offered for sale are all exactly the same
II. The buyers and sellers are so numerous that no single buyer or seller has any
influence over the market price.

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Market Types
2. Monopoly:
is the opposite of perfect competition.

Characteristics:
I. Unique product or service (No substitutes)
II. Single supplier.

Perfect monopolies rarely occur because:

 Few products are so unique that substitutes cannot be used
 Government regulations prohibit monopolies.

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 FYI

• Oligopoly: is a market structure in which a small number of

firms has the large majority of market share. An oligopoly is
similar to a monopoly, except that rather than one firm, two or
more firms dominate the market. (Pepsi & Coca Cola)
• Monopolistic Competition: combining elements of a
monopoly and perfect competition. Like a perfectly
competitive market system, there are numerous competitors in
the market. The difference is that each competitor is
sufficiently differentiated from the others that some can charge
greater prices than a perfectly competitive firm. (market of
music)
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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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The general price-demand relationship
(Perfect Competition Market)
• As the Price (P) ↑ the Demand (D) ↓.
• and as (P) ↓ the (D) ↑
• The relationship between price and
demand can be expressed as the linear
function:
P  a  bD
where
P: price
D: demand
a: the intercept on the price axis
-b: is the slope
aP
D ,b  0
b

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Total revenue depends on price and
demand.
• Total revenue is the product of the selling
price per unit, p, and the number of units
sold. [TR=PD]

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Calculus can help determine the demand
that maximizes revenue.

Solving, the demand that maximizes

revenue is:

Maximum TR is:

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 We can also find maximum profit…
Profit is revenue minus cost, so [Profit=TR-TC)
Pr ofit  TR  TC
Pr ofit  (aD  bD 2 )  (C F  vc .D)

For

Differentiating, we can find the value of D

(optimal demand) that maximizes profit.

Max Profit=??

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
And we can find revenue/cost breakeven.
Breakeven is found when total revenue = total cost.

BEP⇒ TR=TC

Solving, we find the demand at which this occurs .

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Example 2-4 Optimal Demand When Demand Is a
Function of Price

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 $83 per unit. The selling price per unit
is p=$ 180-0.02(D), for this situation,

(a) Determine the optimal volume (at max profit) 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 profitability demand?
TR=PD
Profit=TR-TC
BEP TR=TC
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Example 2-4 Solution

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Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 When the price per unit (P): independent of (D)

TR= P.D , (where the price is constant)

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Example 2-5 Breakeven Point When Price Is
Independent of Demand
An engineering consulting 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 hour. The selling
price is $85.56 per hour. The maximum output of the firm is 160,000
hours per year, and its fixed cost is $2,024,000 per year. For this firm,

(a) What is the breakeven point in standard service hours and

percentage of total capacity?

(b) What is the percentage reduction in the breakeven point

(sensitivity) if fixed costs are reduced 10%; if variable cost per hour is
reduced 10%; and if the selling price per unit is increased by 10%

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Example 2-5 Solution

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Note:

Market competition often creates pressure to lower the breakeven point

of an operation; the lower the breakeven point, the less likely that a
loss will occur during market fluctuations. Also, if the selling price
remains constant (or increase), a larger profit will be achieved at any
level of operation above the reduced breakeven point.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Present Economy Studies

• When alternatives for accomplishing a specific

task are being compared over one year or less
and the influence of time on money can be
ignored.

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Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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• RULE 1: when revenues and other economic benefits are present and
vary among alternatives, choose the alternative that maximizes overall
profitability based on the number of defect-free units of a product or
service produced.

• RULE 2: when revenues and other economic benefits are not present
or are constant among all alternatives, consider only the cost and select the
alternative that minimizes total cost per defect-free units of a product or
service output.

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Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Example 2-8: Choosing the Most Economic Material
Selection

A good example of this situation is illustrated by a part for which annual

demand is 100,000 units. The part is produced on a high-speed turret lathe,
using 1112 screw-machine steel costing $0.30 per pound. A study was
conducted to determine whether it might be cheaper to use brass screw stock,
costing $1.40 per pound. Because the weight of steel required per piece was
0.0353 pounds and that of brass was 0.0384 pounds, the material cost per piece
was $0.0106 for steel and $0.0538 for brass. However, when the
manufacturing engineering department was consulted, it was found that,
although 57.1 defect-free parts per hour were being produced by using steel,
the output would be 102.9 defect free parts per hour if brass were used. Which
material should be used for this part?
The machine attendant was paid $15.00 per hour, and variable overhead costs
were estimated to be $10.00 per hour.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Example 2-8: Solution
Steel Brass
Material cost per piece 0.3*0.035 = $0.0106 per 1.4*0.0384 = $0.0538 per
piece piece
Defect Free per hour 57.1 102.9
Attendant (labor cost) $15/57.1 = $0.2627 per $15/102.9 = $0.1458 per
piece piece

Overhead cost $10/57.1 = $0.1751 per $10/102.9 = $0.0972 per

piece piece
Total Cost per piece 0.0106+0.2627+0.1751= 0.0538+0.1458+0.0972=
$0.4484 $0.2968
revenues are not present, only the costs are presented. Then select the alternative that
minimizes cost per piece: Select Brass

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Example 2-9: Choosing the Most Economic Machine
for Production

Two currently owned machines are being considered for the

production of a part. The capital investment associated with the
machine is about the same and can be ignored. The important
differences between the machines are their production capacities
(production rate X available production hours) and their reject
rates (percentage of parts that cannot be sold). Consider the
following table:

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Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Machine A Machine B
Production rate 100 parts/hour 130 parts/hour
Hours available for 7 hours/day 6 hours/day
production
Percent parts 3% 10%
rejected

The material cost is $6.00 per part, and all the defect-free parts
produced can be sold for $12 each. (Rejected parts have
negligible scrap value.) for either machine, the operator cost is
$15 per hour and the overhead costs is $5 per hour.
(a) Assume that the daily demand for this part is large enough
that all defect-free parts can be sold. Which machine should
be selected?
(b) What would the percent of parts rejected have to be for
Machine B to be as profitable as Machine A?
Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
 Example 2-9: Solution (a)
Machine A Machine B
Production capacity 100*7 = 700 130*6 = 780
Reject units 3%(700) = 21 10% (780) = 78
Defect free 700-21 = 679 780-78 = 702
Material cost 6*700= 4200 6*780= 4680
(Operator + labor) cost (15+5)*7=140 (15+5)*6= 120
Total Cost 4340 4800
Total Revenue 679*12= 8148 702*12= 8424
Profit 8148-4340= 3808 7424-4800= 3624
revenues are present and vary among alternatives, choose the alternative that
maximizes overall profitability based on the number of defect-free units of a
product: Select ( A )

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
2-34. Rework Example 2-9 for the case where the
capacity of each machine is further reduced by 25%
because of machine failures, materials shortages, and
operator errors. In this situation, 30,000 units of good
(non-defective) product must be manufactured during
the next three months. Assume one shift per day and
five work days per week.
a. Can the order be delivered on time?
b. If only one machine (A or B) can be used in Part (a), which one
should it be?

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Copyright ©2009 by Pearson Education, Inc.
Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.
(b) Strategy: Select the machine that minimizes costs per non-defective unit
since revenue for 30,000 units over 3-months is not affected by the choice of
the machine (Rule 2).
Also assume capacity reductions affect material costs but not labor costs.
Machine A
Total cost/day= Material cost + Labor cost + Overhead cost
Total cost/day = (700 units/day)(1 - 0.25)($6/unit)+ ($15/hr +$5/hr)(7
hrs/day)= $3,290/day
Cost/non-defective unit = ($3,290/day)/(509 non-defective units/day)
=$6.46/unit
Machine B
Total cost/day = (780 units/day)(1 - 0.25)($6/unit)+ ($15/hr +$5/hr)(6 hrs/day)
= $3,630/day
Cost/non-defective unit = ($3,630/day)/(526 non-defective units/day)
= $6.90/unit
Select Machine A.

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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Making versus Purchasing (Outsourcing) Studies

In the short run, a company may consider producing an

item in-house even though the item can be purchased
(outsourced) from a supplier at a price lower than the
company’s standard production costs. This could occur
if:
1. direct, indirect, and overhead costs are incurred
regardless of whether the item is purchased from an
outside supplier.
2. the incremental cost of producing an item in the
short run is less than the supplier’s price.

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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 Example 2-12: To Produce or Not to Produce?

A manufacturing plant consist of three department: A, B, and C.

Department A occupies 100 square meters in one corner of the
plant. Product X is one of several products being produced in
Department A. The daily production of product X is 576 pieces.
The cost accounting records show the following average daily
production costs for product X:
Labor 1 operator working 4 hours per day at
$22.5/hr, plus a part time foreman at $30 per
day. (30+(22.5*4))= $120
Material $86.4
Overhead (at $0.82 per square meter of floor area)
0.82*100= $82
Total Cost $288.4 ($0.5 per unit)

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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An outside company that sells product X at $0.35 per piece. Therefore, a
proposal was submitted to the plant manager for shutting down the production
line of product X and buying from the outside company.
However, after examining each component separately, the plant manager
decided not to accept the foreman’s proposal based on the unit cost of product
X:
- Direct labor: the foreman was supervising the manufacture of other
products in Department A in addition to product X, and the operator
working 4 hours per day on product X were not reassigned after this line is
shut down.
- Materials: $86.4
- Overhead: because other products are made in Department A, no reduction
in total floor space requirements will probably occur. Therefore, no
reduction in overhead costs will result from discontinuing product X. it has
been estimated that there will be daily saving in the variable overhead costs
traceable to product X of about $3.0 due to a reduction in power costs.

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Engineering Economy, Fourteenth Edition
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By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
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- Direct labor (operator working): ($22.5)(4 hours) = $90
- Materials: $86.4
- Overhead: $3.0

- Total cost for 576 pieces = $179.4

- Cost per unit = $179.4/576 = $0.316 per unit

Copyright ©2009 by Pearson Education, Inc.

Engineering Economy, Fourteenth Edition
Upper Saddle River, New Jersey 07458
By William G. Sullivan, Elin M. Wicks, and C. Patrick Koelling
All rights reserved.