IENG2002

Industrial
Engineering
Orientation

Week 12: Accounting and Engineering

Economics
 Cost Accounting

Consider a company that uses one production plant to make various models of several
products, each sold at different prices. How can the company determine how much profit it
makes on each model of each product?

Consider a job shop that bids on jobs from customers. How can the company determine the
amount of profit it will make at different bid levels?

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 Cost Accounting

Consider a company that makes a certain part that goes into its product. How can the
company determine how much it costs to make that part in order to compare that cost to
the cost of buying the part from a supplier?

Consider a company that is considering purchasing a new machine to reduce the time
needed to manufacture a part. How can the company determine if the reduction in time is
worth the cost of purchasing the machine?

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 Cost Accounting

Cost accounting, and its newer variant Activity Based Costing, are ways to answer those
types of questions. A lot of common sense goes into cost accounting. The cost for a
company to make a product includes:

1. Direct material cost.

2. Direct labor cost.
3. Everything else.

Costs in the first two categories are relatively easy to compute.

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 Cost Accounting

For example, in the first category, the product might need a certain amount of high-grade
steel, which the company purchases from a particular supplier. The IE can find out from the
purchasing department how much the company pays for steel from that supplier. Scrap
must be taken into account in computing the cost of the steel that goes into the product.

In the second category, the labor cost can be computed for each worker who helps produce
the product by using the hourly rate (including benefits and vacation time) and the time
that worker spends on the part.

The hard part is, of course, the third category which includes all the costs that can’t be
directly allocated to any one product: machinery, office supplies, salaries for maintenance
workers, salaries for management, and so forth.
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 Cost Accounting

Traditional accounting usually allocates these costs in proportion to direct labor costs or in
proportion to machine hours used by each product.

If manufacturing one type of product takes 2/3 of the direct labor costs of a plant, then
traditional accounting allocates 2/3 of the overhead costs to that product. The goal is to use
the allocation basis that best reflects what causes the cost.

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 Cost Accounting

Activity Based Costing extends the idea of linking costs with causes of costs.

First the costs in category 3 are allocated to activities (for example, purchasing, customer
service, running the machine shop) and then those activity costs are allocated to specific
products.

For example, costs of paper might be allocated to activities based on the number of office
workers assigned to each activity (having more office workers causes more use of paper);
the costs of the customer service activity might be allocated among products based the
number of customers or the number of customer orders for each product (having more
customers or having more orders causes more need for the activity of customer service).
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 Engineering Economics

IEs often have to evaluate alternatives:

✓ Which one of several available machines should be purchased to provide a needed
function in the production system?
✓ Will investment in a new production process be worth the anticipated savings?

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 Engineering Economics

Methods for making such decisions are part of the area of industrial engineering called
engineering economics or engineering economy.

Despite its name, this area has more in common with finance than with micro or
macroeconomics.

The methods of engineering economics help the IE pick the most economic decision, that is,
the decision that costs the least money, over the long run.

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 Engineering Economics

Consider the following example. An office manager is deciding which copier to purchase or
lease. Two alternatives are:

✓ Copier A, which can be purchased for $10,000. Maintenance and repairs are estimated
to be $750 per year and the copier will last 5 years.

✓ Copier B, which can be leased at $3000 per year, including all maintenance and repairs.

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 Engineering Economics

YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 TOTAL

Copier A $10.000 $750 $750 $750 $750 $750 $13.750

Copier B $3.000 $3.000 $3.000 $3.000 $3.000 $15.000

That simple analysis is wrong because it ignores the fact that the purchase of Copier A
means that the company gives up any earnings it could have made by investing the
$10,000.

The company could have, for example, bought equipment to produce products and made
money, it could have invested in equipment to save money, or it could just have put the
$10,000 in the bank and earned interest on the money.
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 Engineering Economics

The correct analysis takes account of the time value of money, that is, the fact that $1 has
the same value as $(1+i) one year from now, where i is the rate of return the company can
earn on its money.

For example, if i=12%, $1 now has the same value as $1.12 one year from now and has the
same value as $(1.12)2 or $1.25 two years from now, and so forth, using compound interest.

We can reverse the calculation and compute that $1 one year from now has the same value
as $(1/1.12) = $0.89 now, $1 two years from now has the same value as $(1/1.122) = $0.90
now, and so forth.

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 Engineering Economics

To keep the example simple and ignoring the effect of inflation.

Now we can compare the two alternatives by converting each dollar at future times to its
equivalent value now, called its present value.

𝒏
𝑭𝑽 = 𝑷𝑽 𝟏 + 𝒊

FV: future value,

PV; present value,
𝑭𝑽
i; interest rate, 𝑷𝑽 =
(𝟏 + 𝒊)𝒏
n; number of rate period

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 Engineering Economics

YEAR 0 YEAR 1 YEAR 2 YEAR 3 YEAR 4 YEAR 5 TOTAL

Copier A $10.000 $750 $750 $750 $750 $750 $13.750

Copier B $3.000 $3.000 $3.000 $3.000 $3.000 $15.000

YEAR 1 → YEAR 2 → YEAR 3 → YEAR 4 → YEAR 1 →

i=0,12 YEAR 0 TOTAL
YEAR 0 YEAR 0 YEAR 0 YEAR 0 YEAR 0

Copier A $10.000 $669,64 $597,90 $533,84 $476,64 $425,64 $12.703,58

Copier B $3000 2678,57 2391,58 2135,34 1906,55 $12.112,05

𝑭𝑽 𝟕𝟓𝟎
𝑷𝑽 = 𝒏
= = 𝟔𝟔𝟗, 𝟔𝟒
(𝟏 + 𝒊) (𝟏 + 𝟎, 𝟏𝟐)
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Thank you for your attention.

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