Engineering Economy

Engineering Economy
 ✔ Topic 1 – Introduction to Engineering Economy

✔ Topic 2 – 7 Principles of Engineering Economy

✔ Topic 3 – Cost Concept and Design

✔ Topic 4 – Break Even Analysis

✔ Topic 5 – Present Economy

✔ Topic 6 – Interest

Engineering Economy
 Cost Terminologies

Fixed costs The costs which don’t vary with changing

output. This costs remain constant over a specific
range of operating conditions. It is subject to change
when larger changes in the operating conditions
involved such as plant expansion or shutdown.

Variable costs Costs which depend on the output

produced.
Incremental costs are the additional costs that
result from increasing the output level by one or
more units.

Engineering Economy
 Cont.

Recurring Costs are those that are repetitive and

occur when an organization produces similar goods or
services on a continuing basis, e.g., variable cost
and also a periodic fixed cost like office rent.

Nonrecurring Costs are those that are not repetitive,

e.g., construction cost of the manufacturing plant.

Engineering Economy
 Cont.

Direct costs that can be attributed to a specific

activity or output, e.g., labor and material costs
directly associated with the a product.

Indirect costs that cannot be attributed to a specific

activity or output. Normally, they are allocated
through a selected formula, such as by proportion,
to the outputs or work activities. Cost of common
tools is an example of the indirect costs.

Engineering Economy
 Cont.

Overhead Cost often referred to as overhead or

operating expenses, refer to those expenses
associated with running a business that can’t be
linked to creating or producing a product or service.
They are the expenses the business incurs to stay in
business, regardless of its success level.

Engineering Economy
 Cont.

Opportunity cost is the next best alternative foregone.

The opportunity cost is incurred because there are
only limited resources available.

Sunk Costs are those that have occurred in the past

and irretrievable. The original cost of an equipment is
considered to be the sunk cost for a firm in deciding to
replace it or not.

Engineering Economy
 Cash cost is a cost that involves payment in cash and
results in cash flow;

Book cost or noncash cost is a payment that does not

involve cash transaction; book costs represent the
recovery of past expenditures over a fixed period of
time;

Depreciation is the most common example of book

cost; depreciation is what is charged for the use of
assets, such as plant and equipment; depreciation is
not a cash flow;

Engineering Economy
 Investment Cost or capital investment is the capital
(money) required for most activities of the acquisition
phase;

Working Capital refers to the funds required for

current assets needed for start-up and subsequent
support of operation activities;

Engineering Economy
 Operation and Maintenance Cost includes many of
the recurring annual expense items associated with
the operation phase of the life cycle;

Disposal Cost includes non-recurring costs of

shutting down the operation;

Engineering Economy
 Price Function

Price equals some constant value minus some multiple

of the quantity demanded:

PRICE p=a-b
D Where a is the intercept on the price (p)
axis and –b is the slope.

QUANTITY ( OUTPUT )

The relationship between price and demand can be

expressed as a line

Engineering Economy
 Cost – Volume Relationship

Total Cost
C
o Variable Cost
s
t Fixed Cost

Volume (D)

Engineering Economy
 Total Cost Formula
Total Cost = Total Fixed Cost + Total Variable Cost

TC = CVTOTAL + CFTOTAL
where CVTOTAL = CV x D
= (variable cost/ unit ) (Demand)
thus TC = CV x D + CFTOTAL

REVENUE = Price per unit x Demand

TR = p x D
PROFIT = Total Revenue – Total Cost
TP = TR - TC

Engineering Economy
 Revenue Function

TR = p x D
Substituting the price function,
TR = (a–bD) x D => TR = aD- bD2

Plotting the TR function Using Calculus to get the maximum

point,
TR
TRMax = dTR /dD = a –2bD = 0
Rearranging,
D = a / 2b
*demand that maximizes
total revenue, TR

Volume (D)
Engineering Economy
 Price equals some constant value minus some
a multiple of the quantity demanded:

p=a-bD

a = Y-axis (quantity) intercept, (price at 0

PRICE amount demanded);
b = slope of the demand function;

D = (a – p) / b

QUANTITY ( OUTPUT )
MR=0 MR = dTR / dD = a –2bD = 0

Total Revenue = p x D
PRICE
= (a – bD) x D
TR = Max =aD – bD2

QUANTITY ( OUTPUT )

Engineering Economy
 Cost – Revenue Function

Engineering Economy
 Cost, Volume, and Breakeven
Point Relationship
Scenario 1: When the Price is Varying

TC
Cost
or
TR

CF
TR

Quantity /Volume (D)

Engineering Economy
 Cost, Volume, and Breakeven
Point Relationship
Scenario 1: When the Price is Varying
Profit = TR – TC
Substituting, Profit = p ∙ D – [CF + CV D]
= (a-bD)∙D - CF - CV D
= aD- bD2 - CF - CV D
= - bD2 + - D [a- CV] – CF
Then using calculus, dProfit/dD = -2bD+(a- CV) = 0
Rearranging
D = (a- CV) / 2b *D that maximizes Profit

*demand level where the profit would be realized

Engineering Economy
 Cost, Volume, and Breakeven
Point Relationship
Scenario 1: When the Price is Varying

At Breakeven points, TR = TC
aD- bD2 = CF + CV D
- bD2 + D [a- CV] - CF = 0

Using the Quadratic Formula:

a = -b
b = (a- CV)
c = -CF

Engineering Economy
 Cost, Volume, and Breakeven
Point Relationship
Scenario 2: When the price is NOT varying

TR

TC
Cost
Break Even Point
or
where TR=TC
TR

Quantity /Volume (D)

Engineering Economy
 Cost, Volume, and Breakeven
Point Relationship

Engineering Economy
 Cost, Volume, and Breakeven
Point Relationship
Scenario 2: When the price is NOT varying

TOTAL COST
TC = CFTOTAL + (CV x Demand)

REVENUE = Price per unit x Demand

TR = p x D

PROFIT = Total Revenue – Total Cost

TP = TR - TC

Engineering Economy
 Cost, Volume, and Breakeven
Point Relationship
Scenario 2: When the price is NOT varying

@ BREAK EVEN POINT, TR = TC

pD = CF + CV D
pD - CV D = CF
D[p - CV] = CF

Therefore D = CF / (p - CV)

Engineering Economy
 Practice Problems

1. A postal service carrier works on Sunday

delivering special high priority letters. She can
deliver 15 letters per hour. The hourly fixed cost
are equal $42 and the hourly variable costs
total to $0.50 per letter. How much must the
postal service charge for each letter delivered
in order to break even on Sunday deliveries?

Engineering Economy
 Practice Problems

2. A manufacturing company leases for $100,000 per year a

building that houses its manufacturing facilities. In addition,
the machinery in the building is being paid for installments of
$20,000 per year. Each unit of product produced costs $15
in labor and $10 in materials and can be sold for $40.

a. How many units per year must be sold for the company to
break even?
b. If 10,000 units per year are sold, what is the annual profit?
c. If the selling price is lowered to $35 per unit, how many units
must be sold each year for the company to earn a profit of
$60,000 per year?

Engineering Economy
 Practice Problems

3. A cell phone company has a fixed cost of $1,000,000 per month and
a variable cost of $20 per month per subscriber. The company charges
$29.95 per month to its cell phone customer.
a) What is the breakeven point for this company?

b) The company currently has 95,000 subscribers and proposes to

raise its monthly fees to $39.95 to cover add to add on features.
What is the new breakeven point if the variable cost increases to
$25 per customer per month?

c) If 20,000 subscribers will drop their service because of the

monthly fee increase in part, will the company still be profitable?
Note: the company currently has 95,000 subscribers

Engineering Economy
 Practice Problems

4. A company estimates that the relationship between unit

price and demand per month for a potential new product is
approximated by :
p=$100.00-$0.10D. The company can produce the product
by increasing fixed costs $17,500 per month, and the
estimated variable cost $40.00 per unit. What is the
optimal demand, D*, and based on this demand, should
the company produce the new product? Why?

Engineering Economy
 Practice Problems

5. A company produces circuit boards to update the

outdated computer equipment. The fixed cost is $42,000
per month and the variable cost is $53 per circuit board.
The selling price per unit is p = $150 – 0.02D. Maximum
output of the plant is 4000 units per month.

(a) Determine the optimum value for this product.

(b) What is the maximum profit per month?
(c) At what volumes does break-even occur?
(d) What is the company’s range of profitable demand?

Engineering Economy