Cost Concepts &

Design Economics
Kimberly F. Chan, CIE
What is cost/s?

 anything of values that is foregone to

achieve an objective
 in business term: synonymous with the
term “expenses”
Manufacturing Cost

 Direct Materials Cost

 Direct Labor Cost
 Manufacturing or Factory Overhead
 Direct Materials

 refer to any materials that are used in the final

product and that can be easily traced into it
 Examples
 wood in furniture,
 steel in bridge construction,
 paper in printing firms,
 fabric for clothing manufacturer
 computer chips produced by Intel are raw
materials used by Dell Computer in its
personal computers (finished goods that are
raw materials for other company)
 Direct Labor
 labor costs that go into the production of a
product
 Salary/wages of those personnel who work on
hand in manufacturing a product
 Examples
 labor costs of assembly-line workers,
 labor costs of welders in metal fabricating
industries,
 carpenters or bricklayers in home building,
 machine operators in various
manufacturing operations
Manufacturing Overhead

 include all costs of manufacturing except

direct materials and direct labor

 Examples:
 indirect materials, indirect labor,
maintenance and repairs on production
equipment, heat and light, property
taxes, depreciation, insurance of
manufacturing facilities, and overtime
premium
 NON-MANUFACTURING COSTS
 additional costs in supporting any manufacturing
operations

 Overhead: Heat and light, property taxes, depreciation

or similar terms, associated with its selling and
administrative functions.

 Marketing: Advertising, shipping, sales travel, sales

commissions, and sales salaries. Administrative costs
include all executive, organizational, and clerical costs
associated with the general management of an
organization.

 Administrative functions: Executive compensation,

general accounting, public relations, and secretarial
support.
 STANDARD COSTS
 planned costs per unit of output that are established in
advance of actual production or service delivery
 develop from anticipated direct labor hours, materials,
and overhead categories
 Typical use
 estimating future manufacturing costs
 Measuring operating performance by comparing
actual cost per unit with the standard unit cost
 preparing bids on products or services requested
by customers
 establishing the value of work in process and
finished inventories
COST CLASSIFICATION FOR PREDICTING
COST BEHAVIOR

 Cost behavior
describes how a cost item will react or
respond to changes in the level of
business activity

Classifications:
Fixed Costs
Variable Costs
Incremental Costs
 FIXED COSTS
Cost that are 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.
VARIABLE COSTS
Costs associated with an operation that
varies in total with the quantity of output or
other measures of activity level.

Examples of these costs are the costs of

materials and labor used in a product or
service.
 INCREMENTAL COSTS (INCREMENTAL
REVENUE)
- the additional cost (or revenue) that results
from increasing the output of a system by one
(or more) units

- this cost is often associated with “go – no

go” decisions that involve a limited change in
output or activity level
COST CONCEPTS RELEVANT TO
DECISION MAKING

Costs are an important feature of many

business decisions. In making decisions,
it is essential to have a firm grasp of the
concepts of differential cost, opportunity
cost, and sunk cost.
 DIFFERENTIAL COST
refers to those cost which arise as the
result of a change in operations or policy.
Thus, differential cost may also be
considered as synonymous with
increment cost.
OPPORTUNITY COST
 potential benefit that is given up as you
seek an alternative course of action.
 It 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 (foregone) opportunity
and is often hidden or implied.
SUNK COST

 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.
 involves a past expenditure that cannot
be recovered, or capital that has already
been invested and cannot be retrieved.
Life Cycle Cost

 summation of all the costs related to a

product, structure, system, or service
during its life span.

 It begins with identification of the

economic need or want (requirement)
and ends with retirement and disposal
activities
Category of Life Cycle Cost
 Investment cost is the capital required for
most of the activities in the acquisition
phase. This cost is also called a capital
investment.

 Working capital refers to the funds required

for current assets that are needed for the
start-up and support of operational
activities. The amount of working capital
needed will vary with the project involved,
and some or all of the investment in working
capital is usually recovered at the end of a
project’s life.
Category of Life Cycle Cost
 Operation and Maintenance cost (O&M)
include 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 major part of
the costs in this category.

 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.
BREAK-EVEN ANALYSIS

 Evaluation method employ to determine

the point where revenues and expenses
are equal which serve as an indicator for
businessman/investors/financiers to
know at what level of business activities
they will be able to recover their
capitals.
Assumptions for Break-even
analysis
 All units produced are sold at a constant
price per unit.
 There is no income other than that from
operations.
 The variable costs are directly proportional
to production rate from zero to 100%
capacity.
 Fixed costs are constant regardless of the
number of units produced.
Break-even Point (BEP) Formula

𝐶𝐹
𝑄𝐵𝐸𝑃 =
𝑝 − 𝑐𝑣
where:
QBEP = production quantity (volume) at which
break-even will occur
CF = fixed costs
p = selling price per unit
cv = variable cost per unit
Sample Problem
A firm has the capacity to produce 1,000,000 units of a
product per year. At present, it is able to produce and sell
only 600,000 units yearly at a total revenue of
Php720,000. Annual fixed costs are Php250,000 and the
variable costs per unit are Php0.70.
 Calculate the firm’s annual profit or loss for this
production.
 How many units should be sold annually to break-
even?
 If the firm can increase its sales to 80% of full capacity,
what will its profit or loss be, assuming that its selling
price and variable cost per unit remain constant?
 Draw a break-even chart indicating the above results
on the chart.
 Problem Details & Computation

a.) Profit = Total Revenue - Total Cost

= Php720,000 -[Php250,000 + 0.70(600,000)]
= Php50,000
 b)

Computing for p =

Total Revenue Php720,000

  Php1.20 per unit
Q 600,000 units

Php250,000
QBEP   500, 000 units
(Php1.20 - Php0.70) per unit
c. At 80% capacity (800,000 units per year)
Profit = Total revenue – Total costs
Profit = (800,000 x Php1.20/unit) – [Php250,000 +
(Php0.70/unit x 800,000)]
Profit = Php960,000 – Php810,000
Profit = Php150,000
Sample Problem

 An engineering consulting firm measures its output in terms of

standard service hour unit, which is a function of the personnel grade
levels in the professional staff. The variable cost is Php62 per
standard service hour. The charge-out rate is Php85.56 per hour. The
maximum output of the firm is 160,000 hours per year and its fixed
cost is Php2,024,000 per year. For this firm,
a. What is the break-even point in standard service hours and in the
percentage of total capacity?
b. What is the percentage reduction in the break-even point if fixed
costs are reduced by 10%?
c. What is the percentage reduction in the break-even point if the
variable costs per hour is reduced by 10%?
d. What is the percentage reduction in the break-even point if the
selling price per unit is increased by 10%?
 CF 20, 240, 000
a. QBEP    85,908.32 hours
p  cv 855.60  620
85,908.32 hours
% capacity =  0.5369
160, 000 hours
Or their BEP is 53.69% of their annual capacity.
 EXERCISE
1. A manufacturer produces certain items at a labor
cost per unit of Php315, material cost per unit of
Php100, variable cost of Php3 each. If the item has a
selling price of Php995, how much units must be
manufactured each month for the manufacturer to
break-even even if the monthly fixed cost is
Php461,600.

2. General Electric Company which manufactures

electric motor has a capacity of producing 150 motors a
month. The variable costs are Php4,000 per month, the
average selling price of the motor is Php750 per motor.
Fixed costs of the company amount to Php78,000 per
month which includes all taxes. Determine the number
of motors to be produced per month to break-even.
3. A telephone switchboard 100 pair cable can be made
up with either enameled wire or tinned wire. There will
be 400 soldered connections. The cost of soldering a
connection on the enameled wire will be Php1.65, on the
tinned wire, it will be Php1.15. A 100-pair cable made
up with enameled wire cost Php0.55 per lineal foot and
those made up to tinned wire cost Php0.75 per lineal
foot. Determine the length of cable run in feet so that
the cost of each installation would be the same.

4. The purchase of one of two 500 hp motors A and B is

better considered. Motor A costs Php10,000 and
Php2,000 to install. Motor B costs Php12,000 and
Php3,000 to install. Motor A is 90% efficient, with
Php100 annual maintenance. Motor B is 92% efficient
with Php200 annual maintenance. Fixed charges are 15%
and energy cost Php7.46 an hour to run the less
efficient motor. Fixed charges are based on installed
cost of motors. Determine the break-even point in hours
of use per year. If the actual hours of use per year is
estimated as 3000, which motor would you recommend?
 PRESENT
ECONOMY
What is Present Economy?
 involves the analysis of problems for
manufacturing a product or rendering a
service based on present or immediate
costs.
 usually occur when the effects of time
such as interest and depreciation are
negligible.
 employed when the alternatives to be
compared will provide the same result and
the length of time involved in the study is
relatively short.
Rules:
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.
2. When revenues and other economic
benefits are not present or are
constant among all alternatives,
consider only the costs and select the
alternative that minimizes the total
cost per defect-free unit of product or
service output.
Applications of Present
Economy
 Selection of Material
 Selection of Method
 Site Selection
 Comparison of Proficiency of Workers
 Economy of Tool and Equipment Maintenance
 Economy in the Utilization of Personnel
 Selection of Material
 A diesel engine uses Type A filter and high-grade
lubricating oil costing Php5.50 per liter. With this
filter, the oil and the filter have to be changed
every 500 hours of operation, and 5 liters of oil
have to be added every 100 hours. This filter
costs Php148 a piece. Eighty liters of oil fill the
engine. Another type, filter B, costing Php120
may be used with a lower grade of oil costing
Php4.80 per liter. However, if this filter is used,
the oil and filter have to be changed every 300
hours and 10 liters are added after each 150
hours the engine is used. Which type of filter and
oil would you recommend?
 Problem Details:

Filter A Filter B

Oil Cost Php 5.50/lt. Php 4.80/lt.

Maintenance Oil & filter must be Oil & filter must be

Provision changed every 500 changed every 300
hours of operation and hours of operation and
must add 5 liters of oil must add 10 liters of
every 100 hours of oil every 150 hours of
use. use.
Filter cost Php148 each Php 120 each

Initial Oil 80 liters 80 liters

Requirements
Costing:

Filter A (500 hours) Filter B (300 hours)

Filter cost Php 148 Php 120

Initial Oil Cost (80)(5.50) 440 (80)(4.80) 384

Maintenance 110
(4)(5)(5.50) (1)(10)(4.80) 48
Cost
Total Cost Php 698 Php 552

Lifespan (hours) 500 300

Cost per hours Php 1.3960 Php 1.84

Filter A is recommended
 Selection of Method
 A manufacturer has a contract to produce 5,000
units of a certain device. The device can be
made by highly-trained workmen working
individually. The device can also be made by
less-skilled workmen working together if they are
given specialized equipment and proper
supervision. The highly-trained workmen are
paid Php20.00 per hour, and each can produce
one unit every 2 hours, on the average. The
specialized equipment can be placed in
operation at an original cost of Php60,000 and it
will be worthless at the time all the 5,000 units
are manufactured. With this equipment, four
men, paid at Php15.00 each per hour, and a
foreman, paid at Php25.00 per hour, can do the
work. All the five men working together can
finish one unit in 15 minutes. Determine the
gain or loss if the specialized equipment is used
 Problem Details
 Required no. of production: 5,000 units
Option A: Highly Skilled Workers
 Labor Cost = Php20/hr.
 Output Rate = 1 unit/2 hours

Option B : Less Skilled Workers + Specialized Equipment

No. of workers = 4
Labor Cost = Php15/hr
Foreman (1) Labor cost = Php25/hr/
Specialized Equipment Cost Php60,000 (worthless after
producing the 5000 units the device)
Costing
Option A:

Time required to produce 5,000 units

 2hours 
= 5000   = 10,000 hours
 unit 
Total Cost = (Php20 / hr)(10,000 hrs)
= Php200,000
Option B: Time required to produce 5,000 units
 15min 
= 5,000   = 1250 hours
 unit 

Costs :
Labor Costs
Workers = 4(Php15)(1250) = Php75,000
Foreman = (Php25)(1250) = 31,250
Specialized Equipment = 60,000
Total Cost Php166,250

Gain in favor of Option B of Php33,750

Site Selection
 A certain masonry dam requires 200,000 cu.m. of gravel for its
construction. The contractor found two possible sources for the
gravel with the following data:

Source A Source B
Average distance (gravel pit to 3.0 km 1.2 km
dam site)
Gravel cost (per cu.m.) - Php10.00
Purchase price of pit Php800,000 -
Road construction necessary Php450,000 -
Overburden to be removed - 90,000
(at Php4.20 per cu.m.) cu.m.
Hauling cost per cu.m.-km. Php4.00 Php4.00

Which of the two sites will give lesser cost?

 Costing
Source A Source B

Pit price Php 800,000 Gravel Cost Php 2,000,000

Road Construction 450,000 Overburden 378,000

Cost
Hauling Cost 2,400,000 960,000
Hauling Cost

Total Cost Php3,650,000 Php3,338,000

Source B will give a lesser cost

of Php312,000
 Economy of Tool and Equipment
Maintenance
 A machine used for cutting materials in a factory has the following
outputs per hour at various speeds and requires periodic tool
regrinding at the interval cited.


 Speed Output per hour Tool regrinding

 A 200 pieces every 8 hours
 B 250 pieces every 7 hours
 C 280 pieces every 5 hours


 A set of tools costs Php1,800 and can be ground twenty times. Each
regrinding costs Php18.00 and the time needed to regrind and change
tools is 1 hour. The machine operator is paid Php28.00 per hour,
including the time the tool is changed. The tool grinder who also sets
the tools to the machine is paid Php25.00 per hour. The hourly rate
chargeable against the machine is Php54.00, regardless of machine
speed. Which speed is the most economical?
Problem Details

 Tool Cost =Php1800

 Grinding times = 20 times
 Regrinding Cost = Php18
 Regrinding Time = 1 hr.
 Machine Operator Rate = Php28/hr (operator’s hours
includes the time the tool is changed)
 Grinder Operator Rate = Php25/hr.
 Machine Rate = Php54/hr regardless of speed
Costing Speed C is more economical to use
Speed A (8 Speed B (7 Speed C (5
hrs) hrs) hrs)
Total Output 1600 pcs 1750 pcs 1400 pcs

Costs:

Tool Cost Php 90 Php 90 Php 90

Regrinding Cost 18 18 18

M/C Operator 252 224 168

Grinder 25 25 25
operator

Machine Cost 432 378 270

Total Cost Php817 Php735 Php571

Unit Cost Php0.5106 Php0.42 Php0.4078

Economy in the Utilization of Personnel

 A contractor has a job which should be completed in

100 days. At present, he has 80 men on the job and it
is estimated that they will finish the work in 130
days. Of the 80 men, 50 are each paid at Php220.00 a
day, 25 at Php280.00 a day, and 5 at Php350.00 a day.
For each day beyond the original 100 days, the
contractor has to pay Php500.00 liquidated damages.
a. How many more men should the contractor add so
that he can complete the work on time?
b. If of the additional men, 2 are paid Php280.00 a
day and the rest at Php220.00 a day, would the
contractor save money by employing more men and
not paying the fine?
Problem Details

 Required completion time = 100 days

 Present Situation
Total Workforce = 80men
Estimated completion time =130 days
Workforce Breakdown:
50 men = Php220/day
25 men = Php280/day
5 men = Php350/day
Penalty Cost = Php500/day of delay beyond the required
completion time
Costing: No. of additional Workmen (N)
80men(130 days) = (N+ 80)(100 days)
N = 24 men
Option A : Status quo
Labor Cost :
50(Php220 / day)(130 days) Yes, the contractor
25(Php280 / day)(130 days)  = Php2,567,000 will save money by
 
5 (Php350 / day)(130 days)  employing more men
Penalty : (30days)(Php500 / day) = 15,000 than paying the fine
Total Cost = Php2,582,000

Option B : Add 24 men to meet the required completion time

Labor cost
72(Php220 / day)(100 days)
27(Php280 / day)(100 days)  = Php2,515,000
 
5 (Php350 / day)(100 days) 
 EXERCISE
1. The quarrying cost of marble and granite blocks plus
delivery cost to the processing plant each is Php2,400 per
cubic meter. Processing cost of marble into tiles is
Php200 per square meter and that of granite into tiles
also is Php600 per square meter. If marble has a net yield
of 40 square meters of block and sells at Php400 per
square meter, and granite gives a net yield of 50 square
meters of tiles per cubic meter of block, and sells at
Php1000 per square meter, determine the more profitable
material, considering all other costs to be the same, and
how much is the difference in profit?

2. An equipment installation job in the completion stage can

be completed in 40 days of 8 hour day work, with 40 men
working. With the contract expiring in 30 days, the
mechanical engineer contractor decided to add 10 men
on the job, overtime not being permitted. If the
liquidated damages is Php2,000 per day of delay, and the
men are paid Php80 per day, will the engineer be able to
complete the job on time? How much should he save
money with the addition of workers?
3. An 8-m wide concrete road pavement 500 meters long
is desired to be constructed over a well-compacted
gravel road, together with the necessary concrete curbs
and gutters on both sides. In order to put the subgrade
on an even level grade, a 500 cu. m. of sand filling is
necessary, over which the 10-inch concrete pavement
will be placed. How much will the project cost, allowing
for 15% contingency and assuming the following data?
(a.)Sand fill, including rolling and watering – Php10 per
cu.m.
(b.)Concrete pavement, 10 in. thick (labor and
materials), including curing – Php22 per sq.m.

4. Seawater contains 2.1 pounds of magnesium per ton.

By using the processing method A, 85% of the metal can
be recovered at a cost of Php3.25 per ton of water
pumped and processed. If process B is used only 70% of
the available metal is recovered, at a cost of only
Php2.60 per ton of water pumped and processed. The
two processes are substantially equal as to investment
costs and time requirements. If the extracted material
can be sold for Php2.40 per pound, which processing
method should be used?