MODULE 2:

Introduction and Definitions

Principles of Engineering Economy

Engineering Economy and the Design Process

Costs and Concepts for Decision Making

COST

Cost or expense is one of the important considerations in an economic analysis. We have to recognize that
often, the most difficult and expensive, and time-consuming part of an engineering economy study is the
estimation of costs, revenues, useful lives, residual values, and other data pertaining to the design of
alternatives being analyzed.

Cost estimating is the process by which the present and future cost consequences of an engineering designs
are forecast.

Cost Terminology:

There are a variety of costs to be considered in an engineering economic analysis. These costs differ in their
frequency of occurrence, relative magnitude, and degree of impact on the study.

1. Fixed, Variable, and Incremental Costs

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.

Of course, any cost is subject to change, but fixed costs tend to remain constant over a specific range of
operating conditions. When larger changes in usage of resources occur, or when plant expansion or shutdown
is involved, fixed costs can be affected.

Variable costs

- are those associated with an operation that varies in total with the quantity of output or other
measures of activity level.

For example, the costs of material and labor used in a product or service are variable costs, because they
vary in total with the number of output units, even though the costs per unit stay the same.

Incremental cost (or incremental revenue)

- is the additional cost (or revenue) that results from increasing the output of a system by one (or more)
units. Incremental cost is often associated with “go–no go” decisions that involve a limited change in output or
activity level.

For instance, the incremental cost per mile for driving an automobile may be $0.49, but this cost depends on
considerations such as total mileage driven during the year (normal operating range), mileage expected for the
next major trip, and the age of the automobile.

Also, it is common to read about the “incremental cost of producing a barrel of oil” and “incremental cost to
the state for educating a student.” As these examples indicate, the incremental cost (or revenue) is often quite
difficult to determine in practice.

EXAMPLE 2.1: Fixed and Variable Costs

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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):

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? 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 $12 per cubic yard delivered to the job location?

Solution:

The fixed and variable costs for this job are indicated in the table shown next. Site rental, setup, and removal
costs (and the cost of the flagperson at Site B) would be constant for the total job, but the hauling cost would
vary in total amount with the distance and thus with the total output quantity of yd3-miles (x).

Site B, which has the larger fixed costs, has the smaller total cost for the job. Note that the extra fixed costs of
Site B are being “traded off” for reduced variable costs at this site.

The contractor will begin to make a profit at the point where total revenue equals total cost as a function of the
cubic yards of asphalt pavement mix delivered.

Based on Site B, we have 3($2.75) = $8.25 in variable cost per yd3 delivered

Total cost = total revenue

$90,750 + $8.25x = $12x

x = 24,200 yd3 delivered.

Therefore, by using Site B, the contractor will begin to make a profit on the job after delivering 24,200 cubic
yards of material.

2. Direct, Indirect, and Standard Costs

Direct costs
-are costs that can be reasonably measured and allocated to a specific output or work activity. The
labor and material costs directly associated with a product, service, or construction activity are direct costs.

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 For example, the materials needed to make a pair of scissors would be a direct cost.

Indirect costs
-are costs that are difficult to allocate to a specific output or work activity. Normally, they are costs
allocated through a selected formula (such as proportional to direct labor hours, direct labor dollars, or direct
material dollars) to the outputs or work activities.

For example, the costs of common tools, general supplies, and equipment maintenance in a plant are
treated as indirect costs.

Overhead consists of plant operating costs that are not direct labor or direct material costs.

Examples of overhead include electricity, general repairs, property taxes, and supervision. Administrative
and selling expenses are usually added to direct costs and overhead costs to arrive at a unit selling price for
a product or service.

Standard costs
-are planned costs per unit of output that are established in advance of actual production or service
delivery. They are developed from anticipated direct labor hours, materials, and overhead categories (with
their established costs per unit). Because total overhead costs are associated with a certain level of
production, this is an important condition that should be remembered when dealing with standard cost data

Standard costs play an important role in cost control and other management functions. Some typical uses
are the following:

1. Estimating future manufacturing costs

2. Measuring operating performance by comparing actual cost per unit with the standard unit cost
3. Preparing bids on products or services requested by customers
4. Establishing the value of work in process and finished inventories

3. Cash Cost versus Book Cost

A cost that involves payment of cash is called a cash cost (and results in a cash flow) to distinguish it from
one that does not involve a cash transaction and is reflected in the accounting system as a noncash cost.

This noncash cost is often referred to as a book cost. Book costs are costs that do not involve cash
payments but rather represent the recovery of past expenditures over a fixed period of time.

The most common example of book cost is the depreciation charged for the use of assets such as plant and
equipment. In engineering economic analysis, only those costs that are cash flows or potential cash flows
from the defined perspective for the analysis need to be considered.

Depreciation, for example, is not a cash flow and is important in an analysis only because it affects income
taxes, which are cash flows.

4. Sunk Cost

- is one that has occurred in the past and has no relevance to estimates of future costs and revenues
related to an alternative course of action. Thus, a sunk cost is common to all alternatives, is not part of the
future (prospective) cash flows, and can be disregarded in an engineering economic analysis.

For instance, sunk costs are nonrefundable cash outlays, such as earnest money on a house or money spent
on a passport. The concept of sunk cost is illustrated in the next simple example. Suppose that Joe College
finds a motorcycle he likes and pays $40 as a down payment, which will be applied to the $1,300 purchase
price, but which must be forfeited if he decides not to take the cycle. Over the weekend, Joe finds another
motorcycle he considers equally desirable for a purchase price of $1,230.

For the purpose of deciding which cycle to purchase, the $40 is a sunk cost and thus would not enter into the
decision, except that it lowers the remaining cost of the first cycle. The decision then is between paying an
additional $1,260 ($1,300 − $40) for the first motorcycle versus $1,230 for the second motorcycle.

In summary, sunk costs are irretrievable consequences of past decisions and therefore are irrelevant in the
analysis and comparison of alternatives that affect the future. Even though it is sometimes emotionally difficult
to do, sunk costs should be ignored, except possibly to the extent that their existence assists you to anticipate
better what will happen in the future.
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EXAMPLE 2.2 Sunk Costs in Replacement Analysis

A classic example of sunk cost involves the replacement of assets. Suppose that your firm is considering the
replacement of a piece of equipment. It originally cost $50,000, is presently shown on the company records
with a value of $20,000, and can be sold for an estimated $5,000. For purposes of replacement analysis, the
$50,000 is a sunk cost.

However, one view is that the sunk cost should be considered as the difference between the value shown in
the company records and the present realizable selling price. According to this viewpoint, the sunk cost is
$20,000 minus $5,000, or $15,000.

Neither the $50,000 nor the $15,000, however, should be considered in an engineering economic analysis,
except for the manner in which the $15,000may affect income taxes.

5. 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.

Consider a student who could earn $20,000 for working during a year, but chooses instead to go to school for
a year and spend $5,000 to do so. The opportunity cost of going to school for that year is $25,000: $5,000
cash outlay and $20,000 for income foregone. (This figure neglects the influence of income taxes and
assumes that the student has no earning capability while in school.)

EXAMPLE 2.3 Opportunity Cost in Replacement Analysis

The concept of an opportunity cost is often encountered in analyzing the replacement of a piece of equipment
or other capital asset.

Let us reconsider Example 2.3, in which your firm considered the replacement of an existing piece of
equipment that originally cost $50,000, is presently shown on the company records with a value of $20,000,
but has a present market value of only $5,000.

For purposes of an engineering economic analysis of whether to replace the equipment, the present
investment in that equipment should be considered as $5,000, because, by keeping the equipment, the firm is
giving up the opportunity to obtain $5,000 from its disposal. Thus, the $5,000 immediate selling price is really
the investment cost of not replacing the equipment and is based on the opportunity cost concept.

6. Life-Cycle Cost

- This term 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—whether it is a highway bridge, a jet engine for commercial aircraft, or an automated flexible
manufacturing cell for a factory.

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

For example, the amount of time that a structure or piece of equipment is able to perform economically may
be shorter than that permitted by its physical capability. Changes in the design efficiency of a boiler illustrate
this situation. The old boiler may be able to produce the steam required, but not economically enough for the
intended use.

The life cycle may be divided into two general time periods:
1. The acquisition phase

-begins with an analysis of the economic need or want.

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The analysis necessary to make explicit the requirement for the product, structure, system, or service. Then,
with the requirement explicitly defined, the other activities in the acquisition phase can proceed in a logical
sequence.

The conceptual design activities translate the defined technical and operational requirements into a preferred
preliminary design. Included in these activities are development of the feasible alternatives and engineering
economic analyses to assist in the selection of the preferred preliminary design.

Also, advanced development and prototype-testing activities to support the preliminary design work occur
during this period.

The next group of activities in the acquisition phase involves detailed design and planning for production or
construction. This step is followed by the activities necessary to prepare, acquire, and make ready for
operation the facilities and other resources needed. Again, engineering economy studies are an essential part
of the design process to analyze and compare alternatives and to assist in determining the final detailed
design.

2. The operation phase

-In the operation phase, the production, delivery, or construction of the end item(s) or service and their
operation or customer use occur.

This phase ends with retirement from active operation or use and, often, disposal of the physical assets
involved.

The priorities for engineering economy studies during the operation phase are the following:

(1) Achieving efficient and effective support to operations.

(2) Determining whether (and when) replacement of assets should occur.

(3) Projecting the timing of retirement and disposal activities.

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Figure 2-1 shows relative cost profiles for the life cycle. The greatest potential for achieving life-cycle cost
savings is early in the acquisition phase. How much of the life-cycle costs for a product (for example) can be
saved is dependent on many factors. However, effective engineering design and economic analysis during this
phase are critical in maximizing potential savings.

The cumulative committed life-cycle cost curve increases rapidly during the acquisition phase. In general,
approximately 80% of life-cycle costs are “locked in” at the end of this phase by the decisions made during
requirements analysis and preliminary and detailed design. In contrast, as reflected by the cumulative life-cycle
cost curve, only about 20% of actual costs occur during the acquisition phase, with about 80% being incurred
during the operation phase.

Thus, 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.

The cost elements of the life cycle that need to be considered will vary with the situation. Because of their
common use, however, several basic life-cycle cost categories will now be defined.

7. Investment cost

-is the capital required for most of the activities in the acquisition phase. In simple cases, such as
acquiring specific equipment, an investment cost may be incurred as a single expenditure. On a large, complex
construction project, however, a series of expenditures over an extended period could be incurred. This cost is
also called a capital investment.

8. Operation and maintenance cost (O&M)

-includes many of the recurring annual expense items associated with the operation phase of the life
cycle. The direct and indirect costs of operation associated with the five primary resource areas—people,
machines, materials, energy, and information—are a major part of the costs in this category.

9. Disposal cost

-includes those nonrecurring costs of shutting down the operation and the retirement and disposal of
assets at the end of the life cycle. Normally, costs associated with personnel, materials, transportation, and
one-time special activities can be expected.

These costs will be offset in some instances by receipts from the sale of assets with remaining market value. A
classic example of a disposal cost is that associated with cleaning up a site where a chemical processing plant
had been locate.

10. Recurring Costs

- are those that are repetitive and occur when an organization produces similar goods or services on a
continuing basis. Variable costs are also recurring costs, because they repeat with each unit of output. Also, a
fixed cost such as office space rental that is paid on a repeatable basis is a recurring cost

11. Nonrecurring Costs

– those which are not repetitive, even though the total expenditure may be cumulative over a relatively
short period of time. Usually, for developing capacity or capability to operate. For example the purchase cost
for real estate upon which a plant will be built is a nonrecurring cost, as is the cost of constructing the plant
itself.

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