WEEK 2 :COST CONCEPT AND

DESIGN ECONOMICS
KXIX2002 Engineering Economic Analysis
Chapter objectives

At the end of this topic, you should able to:

1. To analyze short-term alternatives when the time value
of money is not a factor. We accomplish this with three
types of scenarios
▪ Economic breakeven analysis
▪ Cost-driven design optimization
▪ Present economy studies
Cost concept
Cost of nasi lemak
Fixed costs

Fixed costs are those that do not fluctuate with changes in

production level or sales volume. Fixed costs are
independent of output.

Example:
Insurance and taxes on facilities, buildings, lands, equipment,
payments on loans, license fees, management salaries and
advertising.
Variable costs

Variable costs are those that respond directly and

proportionally to changes in activity level or volume.
Variable costs are vary with output.

Example:
Raw materials, hourly production wages, sales commissions,
inventory, packaging supplies and shipping costs.
Incremental costs/ revenue

Incremental cost is the additional cost that results from

increasing the output of a system by one or more units.

Example:
A factory’s workforce is working to full capacity. Adding just
one more unit to output would either require paying
overtime or spending money on recruiting new staff.

Adding to overhead such as water , electricity bills

Revenue

The income generated from sale of goods or services, or

any other use of capital or assets, associated with the main
operations of an organization before any costs or expenses
are deducted.
Example
 Fixed cost
20000+25000+8160
= 53160
 Variab
4.3

$1.15 pe
yard
mile(yd

Fixed cost
20000+25000+8160
Total cost = fixed cost + variable cost = 53160
= total revenue
Recurring vs. Nonrecurring costs

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. A fixed cost also that is
paid on a repeatable basis is a recurring cost.
E.g. office space rental

Nonrecurring costs are those that are not repetitive.

E.g. Purchase cost for real estate upon which a plant will be built,
cost of installing a new machine, emergency maintenance expenses
and etc.
Direct vs. Indirect Costs

Direct costs are those that are reasonably measured and

allocated to a specific output or work activity. There are direct
material cost, direct labour cost and direct expenditure cost.
E.g. the labour and material costs directly associated with a product,
service, or construction activity.

Indirect costs are those that are difficult to attribute or

allocate to a specific output or work activity.
E.g. Costs of common tools, general supplies and equipment
maintenance in a plant.
Overhead costs

Overheads may be allocated to total plant, departments

within a plant and a given item of equipment.
E.g. Indirect material and indirect labour, insurance premiums,
rent, utilities, general repairs, Property taxes, depreciation and
supervision.
Standard costs
Standard costs are representative costs per unit of output that
are established in advance of actual production or service
delivery. They are developed from the direct labour hours,
materials, and support functions (with their established costs
per unit) planned for the production or delivery process.
Example of Standard cost
Necessities, Luxuries and Price Demand
Goods and services may be divided into 2 types:
 Necessities
 Luxurious

For all goods and services, there is a relationship between the

price that must be paid and the quantity that will be demanded
or purchased.

If the same person lived and worked in a different city,

adequate public transportation might be available, and an
automobile would be a luxury. For all goods and services, there
is a relationship between the price that must be paid and the
quantity that will be demanded or purchased. This general
relationship is depicted in Figure 2-2.A
Measures of Economic worth
Iron ore razor blades
Rice to  nasi lemak
Snow in mountain to dry area value

Projection of profit?

Projection of Loss?
Perfect competition vs monopoly
 Perfect competition
 Any given product supplied by large no. of vendors and no
restriction on additional suppliers freedom

 Monopoly – opposite from competition  limited or

single supplier on product
Necessities, Luxuries and Price Demand

Figure
2.2

The relationship between price and demand can be expressed as a

linear function:
Equation 1

Where a is the intercept on the price axis and –b is the slope. Thus,
b is the amount by which demand increases for each unit decrease in
p. Both a and b are constants.
Hence, Equation 2
Total Revenue Function
The total revenue, TR that will result from a business venture
during a given period is the product of the selling price per
unit, p, and the number of units sold, D. Thus,
𝑇𝑅 = 𝑝 × 𝐷 Equation 3
𝑇𝑅 = (𝑎 − 𝑏𝐷)𝐷
𝑇𝑅 = 𝑎𝐷 − 𝑏𝐷2 Equation 4

The demand (D˄) that produce maximum total revenue can be

obtained by solving:
Equation 5
Thus, Equation 6
Calculus can help determine the
demand that maximizes revenue.

Solving, the optimal demand

is (eq. 2-6)

22
Figure 2: total revenue function as a function of demand
Cost, Volume and Breakeven Point
Relationships

Total cost is:

𝐶𝑇 = 𝐶𝐹 + 𝐶𝑉 Equation 7
Where CF and CV denote fixed and variable costs
respectively.

For the linear relationship assume:

𝐶𝑉 = (𝑐𝑉)(𝐷) Equation 8
Where cν is the variable cost per unit.
Breakeven points
BEP = represents the sales amount—in either unit or revenue terms—that is
required to cover total costs (both fixed and variable).
The main purpose of break-even analysis is to determine the minimum output
that must be exceeded in order to make profit. It also is a rough indicator of the
earnings impact of a marketing activity.
It helps to provide a dynamic view of the relationships between sales, costs, and
profits.

Consider 2 scenarios for finding breakeven points:

1. Demand as a function of price.
2. Price and demand are independent of each other.
Figure 2: total revenue function as a function of demand
 breakeven point, D’2
total revenue = total cost
Optimal demand, D*
Scenario 1 total revenue = total cost
volume increase ~ loss

Demand as a function of price.

breakeven point, D’1

total revenue = total cost
Demand volume increase
~ profit

Figure 3: Typical results as a function of demand are depicted when the total
revenue as in Figure 2 and total cost as given by equations 7 and 8 are combined.
 At breakeven point D’1, total revenue is equal to total
cost, and an increase in demand will result in a profit for
the operation.
 Then at optimal demand, D* profit is maximized(equation
10).
 At breakeven point D’2, total revenue and total cost are
again equal, but additional volume will result in an
operating loss instead of a profit.
At any volume (demand), D;
Profit (loss)= total revenue – total costs
= (𝑎𝐷 − 𝑏𝐷2)– (𝐶𝐹 + 𝑐𝑉𝐷)
= −𝐶𝐹 + (𝑎 − 𝑐𝑉)𝐷 – 𝑏𝐷2 for 0 ≤ D ≤ a/b Equation 9

In order for a profit to occur, based on equation 9, and to achieve the

typical results depicted in Figure 3, 2 conditions must be met:
1. (a-cv)> 0; that is the price per unit that will result in no demand has to be
greater than the variable cost per unit.
2. Total revenue (TR) must exceed total cost (CT) for the period involved.

The optimal demand (D*) at which the maximum profit will occur:

Thus, Equation 10
To ensure maximized profit, the sign of the second derivative must be
negative:

Total revenue = total cost (breakeven point)

𝑎𝐷 – 𝑏𝐷2 = C𝐹 + 𝑐𝑉𝐷
−𝑏D2 + (𝑎 − 𝑐𝑉)𝐷 – C𝐹 = 0 Equation 11

Since equation 11 is a quadratic equation with the unknown (D), we can

solve for the breakeven points D’1 and D’2 (the roots of the equation).

Equation 12

With the conditions for a profit satisfied (equation 9), the quantity in the
brackets of the numerator in equation 12 will be greater than zero. This
will ensure that D’1 and D’2 have real positive and unequal values.
Exercise 2
A company produces an electronic timing switch that is used in
consumer and commercial products made by several other
manufacturing firms. The fixed cost (CF) is $73,000 per month,
and the variable cost (cν) is $83 per unit. The selling price per
unit is p = $180 – 0.02(D), based on equation 1.

For this situation:

a) Determine the optimal volume for this product and confirm
that a profit occurs (instead of loss) at this demand, and
b) Find the volumes at which breakeven occurs; that is, what is
the domain of profitable demand?
Solution
 a) Determine the optimal volume for this product and confirm
that a profit occurs (instead of loss) at this demand

Total revenue = total cost (breakeven point)

𝑎𝐷 – 𝑏𝐷2 = C𝐹 + 𝑐𝑉𝐷
Solution
 a) Determine the optimal volume for this product and confirm
that a profit occurs (instead of loss) at this demand
 b) Find the volumes at which breakeven occurs; that is,
what is the domain of profitable demand?
 breakeven point, D’2
total revenue = total cost
Optimal demand, D*
Scenario 1 total revenue = total cost
volume increase ~ loss

Demand as a function of price.

breakeven point, D’1

total revenue = total cost
Demand volume increase
~ profit

Figure 3: Typical results as a function of demand are depicted when the total
revenue as in Figure 2 and total cost as given by equations 7 and 8 are combined.
 Scenario 2
When the price per unit (p)
for a product or service can
be presented more simply as
being independent of demand
(versus being a linear function
of demand, as assumed in
equation 1) and is greater
than the variable cost per
unit (cν), a single breakeven
point results.
Then under the assumption
that demand is immediately
met, total revenue,TR= p.D.
If the linear relationship for
costs in equations 7 and 8 is
also used in the model, the Figure 4: typical breakeven chart with price (p) a
typical situation is depicted in constant
Figure 4.
 Breakeven point when
(D΄)
Exercise 3
An engineering consulting firm measures its output in a
standard service hour unit, which is a function of the personnel
grade level in the professional staff. The variable cost (cν) is $62
per standard service hour. The charge-out rate [i.e. selling price
(p)] is 1.38 (cν) = $85.56 per hour. The maximum output of the
firm is 160,000 hours per year, and its fixed cost (CF) is
$2,024,000 per year.
For this firm, what is the breakeven point in standard service
hours and in percentage of total capacity?
Solution
Cost-driven Design Optimization
Engineers must maintain a life-cycle (i.e. cradle to grave)
viewpoint as they design products, processes, and services.

Such a complete perspective ensures that engineers consider

initial investment costs; operation and maintenance expenses
and other annual expenses in later years; and environmental
and social consequences over the life of their designs.

“Cost-driven design optimization” are simple design models

intended to illustrate the importance of cost in the design
process.
For cost-driven design optimization problems, the two main
tasks are as follows:
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 owning and operating the aircraft?

2. Select the best alternative, each with its own unique value for
the design variable.
For example, what insulation thickness is best for a home.
Insulation acts as a barrier to heat flow and is essential for keeping your
home warm in winter and cool in summer. A well-insulated and well-
designed home provides year-round comfort, cutting cooling and heating
bills by up to half.
In general, the cost models developed in these problems
consist of three types of costs:
1. Fixed cost(s)
2. Cost(s) that vary directly with the design variable
3. Cost(s) that vary indirectly with the design variable

A simplified format of a cost model with one design variable is

the following:
Cost = aX + (b/X) + k Equation 16

where
a = parameter that represents the directly varying cost(s)
b = parameter that represents the indirectly varying cost(s)
k = parameter that represents the fixed cost(s)
X = design variable in question (e.g. weight or velocity)
The steps for optimizing a design with
respect to cost:
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 economic analyses are
referred to as present economy studies.
 We can use these 2 rules
▪ 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 costs and
select the alternative that minimizes total cost per defect-free unit of
product or service output.
Total cost in Material Selection

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Making versus Purchasing

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Trade-offs in Energy Efficiency studies

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 Input power

𝑂𝑢𝑡𝑝𝑢𝑡 𝑝𝑜𝑤𝑒𝑟
Efficiency = 𝐼𝑛𝑝𝑢𝑡 𝑝𝑜𝑤𝑒𝑟

100ℎ𝑝
80% = 125ℎ𝑝

$37,300 + purchase
price + maintenance
cost for a year
Summary
Relation to design project
 Understanding the cost concept is important when performing
economic analysis. This increase the precision of the project and
ease in making decision whether the project should proceed or
not.
Summary
 Cost concepts are those assets relevant to business operations
and decisions. For example: fixed costs, variable costs, direct costs,
indirect costs, recurring costs, nonrecurring costs, revenue,
overhead costs.
 At breakeven point D’, total revenue is equal to total cost.
 Profit occur when total revenue is more than total cost.
 We can use present economy studies in eng. decision by
considering various monetary consequences that occur in a short
time period.