ENGINEERING ECONOMICS

LECTURE 9-10

HUMA RAUF
HITEC , TAXILA
SEPTEMBER 2015 – JANUARY 2016

1
COST TERMINOLOGIES
 Cash Cost – Cash flows e.g bills, salaries, revenue, etc
 Book Cost – For income tax, firm value purposes e.g
Depreciation cost
 Sunk Cost – irrevocable investment due to past decision
 Opportunity Cost – costs of un availed alternatives
 Fixed Cost – unaffected by change in activity e.g. insurance, taxes,
salaries, interest, adminstrative cost
 Variable Cost – associated with operations e.g. cost of
material, labor
 Incremental/Marginal Cost - additional cost to produce e.g. one barrel
of oil, additional mileage etc
Standard Cost
 Standard Cost – planned costs for one unit of output that are
established in advance of actual production or service delivery.
Developed from anticipated direct labor hours, materials and
overhead categories and used to serve the following:

1. Estimating from manufacturing costs

2. Measuring operating performance by comparing actual cost per
unit with the standard unit cost
3. Preparing bids on products/services requested by customers
4. Establishing the value of work in process and finished inventories
 Example – Fixed and Variable Cost
 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 estimated that it will cost $1.15 per cubic yard per mile to hand
the asphalt-paving material from the mixing plant to the job location. Factors
relating to the two mixing sites are as follows (production cost at each site
are the same), rent for A is $4000/- while for site B is $20,000/-
Cost Factor Site A Site B
Average transportation distance 6 miles 4.3 miles
Monthly rental of site $1000 $5000
Cost to setup & remove equipment $15000 $25000
Transportation expense $1.15/yd3-mile $1.15/yd3-mile
Flag person Not required $96/day
The job requires 50,000 cubic yards of mixed asphalt paving material. It is
estimated that 4 months (17 weeks – 5 working days per week ) are required to
get this job done. Compare the two sites in terms of their fixed, variable & total
costs. Cost of return trip is negligible. How many cubic yards of paving material
does the contractor have to deliver before starting to make a profit if paid $ 8.05
per cubic yard to delivered location?
Phases of the Life Cycle vs relative cost
Basic Engineering Economics
Concepts
 Consumer Goods & Services

 Goods & Services which are directly used by people

to satisfy their wants direct relationship to changing
wants/demands of people e.g. Food, Clothing,
Homes, Cars, Television Sets, Haircut, Cinema,
Medical Services, etc
 Producer Goods & Services
 Goods & Services which are used to produce
consumer goods and services – indirect relationship
with demand e.g. machine tools, machinery, factory
building, farm machinery, logistics for material
handling etc
Basic Engineering Economics
Concepts
 Measure of Economic Worth
 Goods and Services are produced and desired
because they have utility – the power to satisfy
human needs and wants.
 a. Necessities
 B. Luxuries
Price Demand Relationship
a – intercept on price axis
-b – slope p – price D - demand
 p= a-bD
 D= a-p
b
Conditions:
a>0
b>0
0<D< a/b
Total Revenue Function
 Total Revenue Function as a
Function of Demand

 TR = price x demand= p.D

 TR= (a-bD) x D = aD- b(D)²
 TR= (a-bD) D
 dTR/dD = a-2bD=0
 D= a/2b

 Maximum TR
 TR= aD- b(D)² (IfD= a/2b)
 TR= a²/2b- a²/4b
 TR = a²/4b
BREAKEVEN ANALYSIS
 Typical Breakeven Chart with Price (p) a constant
Combined Cost, Revenue Functions & Breakeven
Points as Function of Volume & its effect on Profit
Cost, Volume & Breakeven Point
 CT = CF + CV
 CV = cv . D
 Profit (loss) = total revenue – total costs
 = aD- b(D)² - (CF + cv D)
 Profit = - b(D)² + (a- cv) D –CF
 dProfit/dD = - 2b(D) + (a- cv) = 0
 D = (a-cv)/2b (Optimal Demand)
 d²Profit/dD²= - 2b
 Breakeven Point
 TR= Total Cost
 aD- b(D)² = (CF + cv D)
 = - b(D)² + (a- cv) D –CF=0 (Breakeven Point)
 D= -(a-cv) +/- ((a-cv) ² - 4(-b)(-CF))¹/² / 2 (-b)
Examples : 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 CF is $73000/month and the variable cost cv is $83
per unit. The selling price per unit is p=180-0.02(D)
 a. Determine the optimal volume for the product and
confirm that a profit occurs (instead of loss) at this
demand.
 b. Find the volume at which break even occurs, i.e. what
is the range of profitable demand?
Examples :Break even 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 cv is $62 per standard service hour. The
charge-out rate (i.e selling price p is $85.56 per hour. The
maximum output of the firm is 160,000 hours per year,
and its fixed cost CF is 2024000 per year. For this firm,
 a. what is the breakeven point in standard service hours
and in 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 by 10% and if the selling price
per unit is increased by 10%.
Cost Driven Design Optimization
 1. Determine the Optimal Value for a certain
alternative’s design variable. For example,
what velocity of an aircraft minimizes the total
annual costs of operating the aircraft?
 2. Identify the design variable which primarily
drives the cost.
 3. Select the best alternative, each with its
own unique value for the design variable, e.g.
which insulation thickness, what should be
the pipe diameter etc
Economy Decisions

 1. Total cost in Material Selection

 2. Choosing the most economical machine
for production
 3. Best operating speeds
 4. Making versus outsourcing decisions
 5. To produce or not to produce
 6. Investment in electrically efficient
machines, etc
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, engineering economy analysis are referred to as
present economy studies.

 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 product
or service produced.

 RULE 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 products or service output.
Examples
 1. Which material to be selected
 Economical Selection among materials cannot be based solely on the costs of
materials. A change in material will affect the design and processing costs,
shipping, storage costs etc.
 2. Which machine is the most economical for production
 Alternative methods or machines can be used that impact the processing costs,
processing times and product yield.
 3. Which machine speed is the best
 Machine Speeds results in different rate of product output requiring maintenance
repair, oil change at different schedule, Studying their variations w.r.t total costs
incurred is important either for unlimited operations or limited amount of work.
 4. To produce or to purchase (outsourcing)
 For production, capital investment, fixed cost, variable cost, opportunity cost all
require to be considered while cost per item on purchasing to be considered
 5. Should investment be made in energy efficiency
 Long term cost reduction in operations
Choosing the most Economical Material

 A part has an annual demand of 100,000 units. The part is produced on high
speed turret lathe using 1112 screw-machine steel costing $0.30/pound. A
study was conducted to determine whether it would be cheaper to use brass
screw stock, costing $1.40/pound. Because the weight of steel required per
piece was 0.0353 pounds and brass 0.0384 pounds. However, when the
manufacturing engineering department was consulted, it was found that,
although 57.1 defects-free parts per hour were being produced 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 for the turret lathe were estimated to be $ 10.00 per hour
Choosing the most Economic Machine for
Production
 Two currently owned machines are considered for production of a part. The
capital investment for both machines are the same . Their production
capacities (production rate x available production hours) & their reject rates
(percentage of parts that cannot be sold). Consider the following table:
Factors Machine A Machine B
Production rate 100 parts/hour 130 parts/hour
Hours available for production 7 hours/day 6 hours/day
Percent parts rejected 3% 10%

The material cost is $6.00 per part and all defects free parts can be sold at $12
each (rejected parts have zero scrap value. For either machine the operator cost
is $ 15 per hour and the variable overhead rate for traceable costs is $ 5.00 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?
Choosing the best Operating Speed for an
unlimited amount of work
 Lumber is planned at a machine and when it is put for the job, the planer
increases in value by $0.10 per board foot. When the planner is operated at
a cutting speed of 5000 feet per minute, the blades have to be sharpened
after 2 hours of operation, and the lumbar can be planed at the rate of 1000
board feet per hour. When the machine is operating at 6000 feet per
minute , the blades have to be sharpened after 1-1/2 hours of operation and
the rate of planning is 1200 board-feet per hour.
 Each time the blades are changed the machine is shut down for 15 minutes.
The new unsharpened blades 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 which
speed should the planer be operated.
 Labor cost for crew would be the same for either speed.
Choosing to produce or not to produce
 A manufacturing plant consists of three departments A, B & C. Department
A occupies 100 square meters in one corner of the plant. Product X is one
of several products being produced in Dept A. The daily production of
Product X is 576 pieces. The cost accounting records show the following
average daily production costs for Product X.
Direct Labor 1 operator working 4 hours per day at $120
$22.50/hr, including fringe benefits plus
a part time foreman at $30 per day
Direct Material $86.40
Overhead At $ 0.82 per square meter of floor area $82.00

Total Cost $288.40

The department foreman has just learnt that an outside company sells the same
product X at $0.35 per piece. Accordingly the foreman figured a cost of
$0.35(576)=$201.60 resulting in a daily savings of $288.40-$201.60=$86.80.
Therefore a proposal was submitted to plant manager of shutting down the
production line of Product X and buying it from the outside company. However,
after studing all details plant manager decided not to accept the foreman’s
proposal based on the unit cost of Product X. Discuss why?.
Solution Discussion:
 If the manufacturer of Product X is discontinued the firm would save
$90 in direct Labor, $86.40 in direct Material and $3 (It has been
learnt that no reduction in savings would occur in not producing
Product X since this equipment is used for other operations and
occupy the same floor area, only a traceable minute reduction in
electricity bill would occur of $3. This equipment is already in use for
assisting production of other product for the company and Product X
is an additional Product output)
 The estimate of savings this is $179.40 per day, thus the estimate of
cost savings are much less than the $288.40/day as identified the
foreman and again it would not exceed $201.60 to be paid to the
outside company.
 Therefore, the proposal was dismissed by applying rule 2 of cost
savings.
Investing in Electrical Efficiency
 Two pumps capable of delivering 100 hp to an agricultural application are
being evaluated in a present economy study. The selected pump will only
be utilized for one year and it will have no market value at the end of the
year. Pertinent data are summarized below:
Pump abc Pump xyz
Purchase Price $2900 $6200
Annual Maintenance $170 $510
Efficiency 80% 90%

If Electric Power Costs $0.10 per KWh and the pump will be operated 4000
hours per year, which pump should be chosen. Note 1 hp = 746 kW.
Solution
 The annual expense of elecrric power for the ABC pump
is:
 (100hp/0.80)(0.746 KW/hp)($0.10/kWh)(4000 hrs/yr) =
$37300.
 For the XYZ Pump, the annual expense of electric power
is:
 (100hp/0.90)(0.746 KW/hp)($0.10/kWh)(4000 hrs/yr) =
$33156
 Thus the annual cost of owning and operating Pump ABC
is $40,370, while Pump XYZ for one year is $39,866.
Therefore Pump XYZ is chosen despite of its higher cost
proce and annual maintenance due to its efficiency in
energy savings.
Assignment 2 & 3
 Assignment 2: Chapter 2 Cost Concepts and
Design Economics End Exercise Problem 2.30
– 2.44
 Assignment 3: Presentation on Cost Reduction
Measures (Choose any part of Toyota or similar
technical manufacturing concern and send me
the topic so as I make sure that no topic is
repeated)
 Assignment 3 would be assessed on question
answers during the presentation