EMT 341/3

Management
for Engineers
Lecture 5
Part II : Economics
Sem 2 2020/21
 Cost Concepts And Design Economics
Purpose : analysing short-term alternatives when the time value of
money is not a factor
Engineering decision which Profit = Revenue - Cost
based on economy (money)
criteria

2
 Outline
š Basic Terminology of Cost and Revenue
š Law of Supply and Demand
š Cost, Production Volume, and Breakeven
Point Relationships
š Economic Breakeven Point
š Point of Maximum Profit
š Cost Estimation Techniques 3
 Basic Terminology of Cost and Revenue
Definition :An amount that has to be paid or given up in
order to get or produce something.

monetary valuation Time and utilities consumed

Effort
Resources Risks incurred
Material

Missing or forgone opportunity 4

 Basic Terminology of Cost and Revenue
Accounting cost is a cost which Analytical cost is a cost that
does not involve a cash involves payment of cash
transaction and is reflected in the (and results in a cash flow)
accounting system, such as an • Fixed and Variable Cost
anticipated saving due to certain • Total, Average and
proactive measures taken in Marginal Costs
product manufacturing or the • Incremental and Sunk
opportunity lose. Costs
• Opportunity Cost and
Actual Cost
• Explicit Cost and Implicit
Cost 5
 Basic Terminology of Cost and Revenue
Fixed Definition: unaffected by changes in activity level over a feasible
costs range of operations for the capacity or capability available.
Factor : capital cost, general management and administrative
salaries, license fees, and interest costs on borrowed capital.
“The cost you have to pay when you produce nothing”
Variable Definition: are those associated with an operation that vary in total
costs with the quantity of output or other measures of activity level
(operating cost).
Example of variable costs include : costs of material and labour used in a
product or service, because they vary in total with the number of output units
-- even though costs per unit remain the same.

FIXED (FC) + VARIABLE COST (VC) = TOTAL COST (TC) 6

Basic Terminology of Cost and Revenue
Short Run Production/Output

FIXED (FC) + VARIABLE COST (VC)

= TOTAL COST (TC)

7
Basic Terminology of Cost and Revenue
Incremental (Marginal) Cost / Revenue

Incremental Cost = the additional cost (or revenue)

that results from increasing the output of a system by
one (or more) units.

Considered in long production run

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 Basic Terminology of Cost and Revenue
• Definition : costs that can be reasonably measured and allocated
Direct to a specific output or work activity.
costs • The labour and material costs directly associated with a product,
service, or construction activity are direct costs.
• For example, the materials needed to make a pair of scissors
would be a direct cost.

• Definition : costs that are difficult to allocate to a specific output

Indirect or work activity.
• Normally, they are costs allocated through a selected formula
costs (such as proportional to direct labour hours, direct labour 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.
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 Basic Terminology of Cost and Revenue
Examples
Direct cost Indirect cost examples
•Physical assets •Physical assets
•Maintenance and •Maintenance and
operating costs (M&O) operating costs (M&O)
•Materials •Materials
•Direct human labour (costs •Direct human labour (costs
and benefits) and benefits)
•Scrapped and reworked •Scrapped and reworked
product product
•Direct supervision of •Direct supervision of
personnel personnel 10
 Basic Terminology of Cost and Revenue
• Planned costs per unit of output that are
established in advance of actual
production or service delivery.
Standard • They are developed from anticipated
direct labour hours, materials, and
costs overhead categories (with their
established costs per unit).
• Standard costs play an important role in
cost control and other management
functions
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 Basic Terminology of Cost and Revenue
• Is one that has occurred in the past and cannot be
recovered.
• It has no relevance to estimates of future costs and
Sunk revenues related to an alternative course of action.
Cost • 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 non-refundable cash
outlays, such as earnest money on a house or
money spent on a passport. 12
 Basic Terminology of Cost and Revenue
• Life-cycle cost is the summation of all
costs, both direct and indirect, recurring
Life-Cycle and nonrecurring, related to a product,
Cost infrastructure, system, or service during its
(LCC) life span.
• Product life cycle begins with the
identification of the economic need or
want (feasibility/market study, product
specifications, R&D activities) and ends
with the retirement and disposal activities.
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Basic Terminology of Cost and Revenue
Life-Cycle Cost Analysis Principle

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 Basic Terminology of Cost and Revenue
Total Cost, Average Cost And Marginal Cost
Average Cost (cost to produce 1 unit of
product) = Total Cost / Total Number of
Produced Unit

Marginal Cost = the change in the Total

Cost that arises when the quantity
produced is incremented by one unit,
that is, it is the cost of producing one
more unit of a good
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 Basic Terminology of Cost and Revenue
Output Fixed Variable Total Marginal Av.Fixed Av.Var. Cost Av. Cost
(Q) Cost Cost (VC) Cost Cost Cost AVC=VC/q AC=TC/Q
(FC) (C) (MC) AFC=FC/Q
0 48 0 48
1 48 25 73 25 48 25 73
2 48 46 94 21 24 23 47
3 48 66 114 20 16 22 38
4 48 82 130 16 12 20.5 32.5
5 48 100 148 18 9.6 20 29.6
6 48 120 168 20 8 20 28
7 48 141 189 21 6.9 20.1 27
8 48 168 216 27 6 21 27
9 48 198 246 30 5.3 22 27.3
10 48 230 278 32 4.8 23 27.8
11 48 272 320 42 4.4 24.7 29.1
MC < AC : AC decreases
MC > AC : AC increases MC = AC : AC at the minimum 16
 Basic Terminology of Cost and Revenue
Revenue Total Revenue

Total money received from the

payment in terms of money sale of all products
which is received by the seller (or
company) from sale of product
or services to the buyer (or Average Revenue
consumer)
(AR) = TR / No of units sold
Marginal Revenue

(MR) = Net addition to TR when one additional unit is sold. 17

MR = Change in TR / change in quantity sold = Δ TR / ΔQ
 Basic Terminology of Cost and Revenue
Example
i) A leather craftsman who sells boots for RM 100 per pair. If he regularly sells
50 pairs per month, calculate the total revenue for this business.

ii) The craftsman is considering lowering his prices to RM 80 per pair in order
to boost sales. If he sells the same amount each month, calculate his total
revenue.
iii) Calculate how many more boots he would need to sell to make the total
revenue amount before the boost sales?

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 Basic Terminology of Cost and Revenue
Example
i) A leather craftsman who sells boots for RM 100 per pair. If he regularly sells
50 pairs per month, calculate the total revenue for this business.
Answer : RM 100 x 50 = RM 5,000
ii) The craftsman is considering lowering his prices to RM 80 per pair in order
to boost sales. If he sells the same amount each month, calculate his total
revenue. Answer : RM 80 x 50 = RM 4,000
iii) Calculate how many more boots he would need to sell to make the total
revenue amount before the boost sales?
Answer :
RM 5,000 (Total Revenue) = X (Quantity Sold) x RM 80 (Price)
Quantity Sold = RM 5,000 / RM 80
Quantity Sold = 62.5 ~ 63 boots 19
 Outline
š Basic Terminology of Cost and Revenue
š Law of Supply and Demand
š Cost, Production Volume, and Breakeven
Point Relationships
š Economic Breakeven Point
š Point of Maximum Profit
š Cost Estimation Techniques 20
 Law of Supply and Demand
1. The chart shows the law of supply using a supply curve,
which is upward sloping.
Law of Supply 2. A, B and C are points on the supply curve. Each point on
the curve reflects a direct correlation between quantity
supplied (Q) and price (P).
3. At point A, the quantity supplied will be Q1 and the price
will be P1, and so on. The supply curve is upward sloping
because, over time, suppliers can choose how much of
their goods to produce and later bring to market. At any
given point in time however, the supply that sellers bring
to market is fixed, and sellers simply face a decision to
either sell or withhold their stock from a sale; consumer
demand sets the price and sellers can only charge what
the market will bear.
4. If consumer demand rises over time, the price will rise,
and suppliers can choose devoted new resources to
production (or new suppliers can enter the market)
which increases the quantity supplied.
5. Demand ultimately sets the price in a competitive
market, supplier response to the price they can expect
to receive sets the quantity supplied.
6. The law of supply is one of the most fundamental
concepts in economics. It works with the law of demand
https://www.investopedia.com/terms/l/lawofsupply.asp to explain how market economies allocate resources
and determine the prices of goods and services. 21
 Law of Supply and Demand
1. Supply and demand is one of the basic ideas
of economics.
2. In a free market, the price of a product is
determined by the amount of supply of the
product and the demand for the product.
3. The supply of a product is how much of the
product is available for purchase at a given
price.
4. The law of supply says that as the price of a
product increases, companies will build more
of the product.
5. When graphing the supply vs. the price of a
product, the slope rises as shown in this
graph.

https://www.youtube.com/watch?app=desktop&v=WZ0I9t9QoZ0 22
https://www.ducksters.com/money/supply_and_demand.php
 Outline
š Basic Terminology of Cost and Revenue
š Law of Supply and Demand
š Cost, Production Volume, and Breakeven
Point Relationships
š Economic Breakeven Point
š Point of Maximum Profit
š Cost Estimation Techniques 23
Cost, Production Volume, and Breakeven Point
Relationships
1. A method of cost accounting that looks at
the impact that varying levels of costs and
volume have on operating profit.
2. The cost-volume-profit analysis, also
commonly known as break-even analysis,
looks to determine the break-even point for
different sales volumes and cost structures,
which can be useful for managers making
short-term economic decisions.
3. The cost-volume-profit analysis makes
several assumptions, including that the sales
price, fixed costs, and variable cost per unit
are constant.
4. Running this analysis involves using several
equations for price, cost and other
variables, then plotting them out on an
economic graph.
https://www.investopedia.com/terms/c/cost-volume-profit-analysis.asp
https://psu.pb.unizin.org/hmd329/chapter/cvp/
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 Outline
š Basic Terminology of Cost and Revenue
š Law of Supply and Demand
š Cost, Production Volume, and Breakeven
Point Relationships
š Economic Breakeven Point
š Point of Maximum Profit
š Cost Estimation Techniques 25
Economic Breakeven Point
1. In accounting, the breakeven point is
calculated by dividing the fixed costs
of production by the price per unit
minus the variable costs of
production.
2. The breakeven point is the level of
production at which the costs of
production equal the revenues for a
product.
3. In investing, the breakeven point is
said to be achieved when the
market price of an asset is the same
as its original cost.
https://www.investopedia.com/terms/b/breakevenpoint.asp
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 Economic Breakeven Point
• Break Even Analysis in economics, business, and cost
What is Break accounting refers to the point in which total cost and total
revenue are equal.
Even Analysis? • A break even point analysis is used to determine the number of
units or dollars of revenue needed to cover total costs (fixed and
variable costs).
Formula for Break Even Analysis
Break even quantity = Fixed costs / (Sales price per unit – Variable cost per unit)
Where:
•Fixed costs are costs that do not change with
varying output (e.g., salary, rent, building
machinery).
•Sales price per unit is the selling price (unit selling
price) per unit.
•Variable cost per unit is the variable costs incurred
to create a unit.
https://corporatefinanceinstitute.com/resources/knowledge/modeling/break-even-analysis/ 27
 Outline
š Basic Terminology of Cost and Revenue
š Law of Supply and Demand
š Cost, Production Volume, and Breakeven
Point Relationships
š Economic Breakeven Point
š Point of Maximum Profit
š Cost Estimation Techniques 28
 Point of Maximum Profit
1. The Profit Maximization Rule states that if a firm chooses to maximize its profits, it must choose that level of
output where Marginal Cost (MC) is equal to Marginal Revenue (MR) and the Marginal Cost curve is
rising. • Marginal Cost is the increase in cost by producing
2. The profit maximization rule formula is MC = MR one more unit of the good.
• Marginal Revenue is the change in total
revenue as a result of changing the rate of sales
by one unit.
• Marginal Revenue is also the slope of Total
Revenue.
Profit = Total Revenue – Total Costs
Based on the graph:
• At A, Marginal Cost < Marginal Revenue, then for each
additional unit produced, revenue will be higher than
the cost so that you will generate more.
• At B, Marginal Cost > Marginal Revenue, then for each
extra unit produced, the cost will be higher than
revenue so that you will create less.
• So, optimal quantity produced should be at MC = MR
https://www.intelligenteconomist.com/profit-maximization-rule/ 29
 Outline
š Basic Terminology of Cost and Revenue
š Law of Supply and Demand
š Cost, Production Volume, and Breakeven
Point Relationships
š Economic Breakeven Point
š Point of Maximum Profit
š Cost Estimation Techniques 30
 Cost Estimation Techniques
Method Description
Approach Explain the bottom-up and design-to-cost (top down) approaches to cost
estimation.
Unit method Use the unit method to make a preliminary cost estimate.
Cost index Use a cost index to estimate a present cost based on historical data.
Cost capacity Use a cost-capacity equation to estimate component, system, or plant costs.
Factor method Estimate total plant cost using the factor method.
ABC allocation Use the Activity-Based Costing (ABC) method to allocate indirect costs.
Indirect cost Allocate indirect costs using traditional indirect cost rates.
rates
Ethics and Describe how biased estimation can become an ethical dilemma.
profit
Reference book: Engineering Economy , Leland Blank, Anthony Tarquin, 7th edition
https://www.float.com/blog/a-quick-guide-to-project-cost-estimating/ 31
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