Economic Decision Making

In this chapter we concentrate on a set of analytical tools that are used across all
engineering disiplines for estimating the economic performance of proposed designs.

The importance of engineering economics to engineering design is that money has a

time value.

Economic Decision Rules:

There are different perspectives that can be used to compare the costs of a set of
design alternatives.

Lowest initial cost:

Lowest Life-Cycle cost:
Average Annual Rate of Return:
Payback Period:

İlhan Konukseven ME 407 Mechanical Engineering Design 1

 Problem: as a design engineer select the electric motors to drive the conveyor belts in a
new factory.

Two alternatives: A Motors and B Motors

1. A Motors will cost $30,000 to purchase

B Motors will cost $20,000 to purchase

2. During the expected five-year life of the motors

A Motors will cost $1,000 annually for maintenance
B Motors will cost $2,000 annually for maintenance

3. B Motors will have to be rebuilt at the end of the third year at a cost of $3,000

4. At the end of the fifth year,

the B Motors are worthless
A Motors have a salvage value of $4,000

5. A Motors will cost $3,000 a year to run

B Motors will cost $3,500 a year to run

6. Electric rates are expected to increase five percent each year over the next five years

7. A Motors are more reliable, the conveyor belts won’t have as much downtime, so annually
production output will be $500 higher than the B Motors.

İlhan Konukseven ME 407 Mechanical Engineering Design 2

 Classical Engineering problem:
How to chose between one option with high initial cost and low operating cost ( such as A Motors)
(another option) or low initial cost but high operating costs ( such as B Motors)

Before any comparison can be made, the engineer has to decide how that comparison is going to be
made: A decision rule, or basis for making the choice, must be adopted.

Decision rules:
Lowest initial cost: “Lowest initial cost” decision rule might be preferred in situations where the
funds available for investment are restricted. (In the example “lowest initial cost” rule means that
the B motors are preferred to A motors.
Lowest Life-Cycle cost: treat all costs equally, regardless of when they accur over the expected
life of the product or project. The A Motors are preferred alternative to the “lowest life-cycle
cost”

Components of Life Cycle Cost

İlhan Konukseven ME 407 Mechanical Engineering Design 3
 Average Annual Rate of Return: A rate of return decision rule separates initial costs from
downstream expenses.

Incremental Invesment
= Initial cost of more expensive option -
Initial cost of less expensive option
= (30,000 – 20,000) = $10,000

Downstream Benefits (benefits for A)

= Avoidance of rebuilding cost +
Income from salvage +
Savings on maintenance costs over five years +
Increase revenue from productivity enhancement +
Annual savings on electricity costs
= [3.00+4.00+(10.00-5.00)+2.50+(3.50-3.00)
+(3.68—3.15)+(3.86-3.31)+(4.05-3.47)+
(4.25-3.65)]($1000)
= $17,260

Average Annual Benefit

= Downstream Benefits / Project Duration
= 17,260/5 = $3,450
Components of Life Cycle Cost
Average Annual Rate Return
= [Average Annual Benefit/Incremental Investment]100
= [$3,450/$10,000]100=34.5%

İlhan Konukseven ME 407 Mechanical Engineering Design 4

 Payback Period: Payback period decision rule separates initial costs from
downstream expenses.

Benefits in 1st Year

= [(maint)1 + (prod)1 + (elec)1]
= (1.00 + 0.50 + 0.50) = $2,000

Benefits in 2nd Year

= [(year 1) + (maint)2 + (prod)2 + (elec)2]
= (2.00 + 1.00 + 0.50 + 0.53) = $4,030

Benefits in 3rd Year

= [(2 years) + (maint)3 + (prod)3 + (elec)3 + (rebld)]
= (4.03 + 1.00 + 0.50 + 0.55 + 3.0 ) = $9,050

Benefits in 4th Year

= [(3 years) + (maint)4 + (prod)4 + (elec)4] Components of Life Cycle Cost
= (9.05 + 1.00 + 0.50 + 0.58 ) = $11,13

The payback period is ~3.5 years

All down stream transactions are treated

on an equal basis as an initial costs.

Time Value of Money !

İlhan Konukseven ME 407 Mechanical Engineering Design 5
 MATHEMATICS OF TIME VALUE OF MONEY

Simple Interest:
F : Future worth
P : Present worth
i : Annual interest
n : number of years

Future Worth:
F = P+nPi = P(1+ni)

($1000 in hand today is worth $1600 available in only 6 years at %10 simple interest)
F= $1000[1+6(0.10)]=$1600

Present Worth:

F $1600
P   $1000
1  ni 1  0.6

İlhan Konukseven ME 407 Mechanical Engineering Design 6

 MATHEMATICS OF TIME VALUE OF MONEY

Compound Interest: In compound interest, the interest due at the end of a

period is not paid out but is instead added to the principle.

F : Future worth
P : Present worth
i : Annual interest
n : number of years

Future Worth:
First Period : F1  P  P i  P (1  i )
Second Period : F2  P (1  i )  iP (1  i )  P (1  i )(1  i )  P (1  i ) 2
.
nth Period : Fn  P (1  i ) n (1  i) n Single Payment compound-amount factor
(interest compounded at periods other than one year)
n : number of years
r : Nominal annual interest rate
a : Number of interest periods in one year
i : Interest rate per interest period ( i=r/a )
n
 r 
a
Compounding at the end of shorter
F  P  1    periods, such as daily, monthly. . .
 a 

İlhan Konukseven ME 407 Mechanical Engineering Design 7
 Engineering economy was developed to deal with sums of money at different
times in the future. A good methodology for setting up problems is to place
the money amounts on a money-time diagram. Income is placed above the line
and costs are placed below the line.

Income

Costs
Uniform Annual Series Money-time diagram

Uniform series of receipts or disbursements occuring equally at the end of each period.
Examples:
-Payment of a debt on the instalment plan
-Setting aside a sum F that will be available at the future date for replacement of
equipment
-Retirement annuity that consists of a series of equal payments instead of a lump sum
payments

Equivalence of a uniform annual series

Figure shows that if an annual sum R is invested at the end of each year for 3 years,
the total sum F at the end of 3 years will be the sum of the compound amount the
 2
 
individual investments R F  R 1  i  R 1  i  R 
İlhan Konukseven ME 407 Mechanical Engineering Design 8
 For the general case of n years:

F  R1  i   R1  i   . . . . . R1  i   R1  i   R

n 1 n 2 2

F 1  i   R1  i   R1  i   R1  i   . . . . . R1  i   R1  i 

n n 1 n 2 2

F 1  i   F  R1  i   R
n


iF  R 1  i   1
n
 Fn  P (1  i ) n

R : annual sum is invested at the end of each year (aside money )

F : the sum of the compound amount

FR
1 i  1
n
Gives sum of n uniform payments of R when the interest rate is i
i
i
RF Set aside money for paying off debt or buy/replace equipment
1  i n  1

PR
1  i  1
n
Present worth of a uniform series of payments R
i 1  i 
n

i 1  i 
n

RP Capital recovery: The annual payment needed to return the initial
1  i n  1 capital investment P plus interest on that investment at a rate i
over n years

İlhan Konukseven ME 407 Mechanical Engineering Design 9

 Example:
What annual investment must be made at 10% to provide funds for replacing a $10,000
machine in 20 years?

i Sinking fund to provide funds for replacing

RF
1  i n  1
0.1
R  $10,000  $174.60 per year for the sinking fund
1  0.120  1

What is the annual cost of capital recovery of $10,000 at 10% in 20 years?

i 1  i 
n

RP Capital fund recovery

1  i n  1
0.11  0.1
20

R  10,000  $1,174.60 per year for capital recovery

1  0.120  1

It is conventional to assume that R occurs at the end of each period.

If a beginning-of-period payment Rb is required, it can be determined readily by discounting
R one year to the present

R  Rb (1  i )
İlhan Konukseven ME 407 Mechanical Engineering Design 10
 COST COMPARISON

A typical decision is which of two courses of action is the least expensive when time value
of money is considered.

I. Present Worth Analysis

All costs or receipts are discounted to the present time to calculate the net present
worth.

Example: Two machines each have a useful life of five years. If money is worth 10%,
which machine is more economical? Present worth Compound Interest
1
PR
1  i  1
n
F  P (1  i ) n
 P  F
Discount all costs back to the present time: (1  i ) n
i 1  i 
n

PA  25,000  2000  500 

1  0.1  1
5

 3000
1
 $28,823

0 .1 1  0 .15
1  0 .1 5

PB  15,000  4000
1  0.1  1  3500 1
5
 $32,793
0.11  0.15 1  0.13

İlhan Konukseven ME 407 Mechanical Engineering Design 11

 Both alternatives had the same life. If alternatives are based on different time periods,
we may handle the problem using common multiple of the individual periods

We may use a common 6-year period, in which we would replace machine A three times
and replace machine B twice.

İlhan Konukseven ME 407 Mechanical Engineering Design 12

 II Annual Cost Analysis

The cost flow over time is converted to an equivalent annual cost or benefit. This method
works well when the alternatives have different time periods.

i 1  i 
n
i
RP RF
1  i n  1 1  i n  1
Capital recovery Aside money for
replace equipment

0.11  0.1
20

RA  10,000  4000  $5,175

1  0.120  1

0.11  0.1
35
1
RB  18,000  3000  3000  $4,855
1  0.135  1 1  0.135  1
Machine B has the lowest annual cost and is the most economical

İlhan Konukseven ME 407 Mechanical Engineering Design 13

 III Capitalized Cost Analysis

This is a special case present worth analysis for a project that exists in perpetuity (n=).
The concept is originally developed for use with public works, such as dums and water-works,
that have long lives and provide services that must be maintained indefinitely.

i 1  i 
n

Capital Recovery for n number of years

K  P  Pn
1 i  1
n

i 1  i 


Capital Recovery for  years

1  i   1
i

0.11  0.1
10

K  20,000
1  0.1  1
10

1000  600
 $48,540
0.11  0.1 0.11  0.1
 

1  0.1  1 1  0.1  1
0.11  0.1 0.11  0.1
15 15

K  6,000
1  0.1   1
15
 500
1 1  0.115  1  4,800  $55,733
0.11  0.1 1  0.115 0.11  0.1 0.11  0.1
  

1  0.1  1 1  0.1  1 1  0.1  1

Each of the three methods of analysis will give the same result when applied to the same problem.

İlhan Konukseven ME 407 Mechanical Engineering Design 14

 COST EVALUATION

An engineering design is not complete until the cost to build the design or manufacture
the product is known.

For most products and designs, cost is next to performance in importance.

This Section emphasis on how cost estimates can be made early in the design process.

Importance of cost estimate:

1- provide information to be used in establishing the selling price
2- determine the most economical method, process, or material for manufacturing a
product
3- can be used as a basis for a cost-reduction program
4- determine standards of production performance that may be used to control costs
5- provide input concerning the profitability of a new product.

CATEGORIES OF COSTS

There are two broad categories:

1- Nonrecurring costs: 2- Recurring costs:

These are one time costs (capital costs) These costs are direct functions of
the manufacturing costs.
Depreciable facilities Nondepreciated (Operating or Manufacturing costs)
capital costs
Plant building Land
Manufacturing equipment
Tools
İlhan Konukseven ME 407 Mechanical Engineering Design 15
 Another classification:

1-Fixed Costs 2- Variable Costs

Independent of the rate of production Change with the production rate
1- Indirect plant cost 1. Materials
(a) Invesment costs 2. Direct labor (including fringe benefits)
Depreciaition on capital investment 3. Direct production supervision
Interest on capital investment and inventory 4. Maintenance costs
Property taxes 5. Power and utilities
Insurance 6. Quality-control staff
(b) Overhead costs 7. Royalty payments
Technical services (engineering) 8. Packaging and storage costs
Product design and development 9. Scrap losses and spoilage
Nontechnical services (office pers, security..)
General supplies
Rental of equipment
2- Management and administrative expenses
(a) Share of corporate executive staff
(b) Legal staff
(c) Share of corporate R&D staff
(d) Marketing staff
3- Selling expenses
(a) Sales force
(b) Delivery and warehouse costs
(c) Technical service staff

İlhan Konukseven ME 407 Mechanical Engineering Design 16

 -Depreciation
-Light -Engineering
The way the elements of cost -Power -Taxes
Profit
build up to establish a selling -Maintenance -Office staff
price is shown below -Supplies -Purchasing Sales
-Factory expenses
indirect labor General
expenses Selling
Factory Total price
Manufac
expenses cost
turing
Direct Factory
cost
material Prime cost
Direct cost
labor

A concept that provides a rough estimate of the investment cost for a new product is
the turn over ratio:
annual sales
Turnover 
total investment
Variable costs are depend on the rate or volume of production and fixed costs do not.
The determination of the production lot size to eceed the break-even point and produce
a profit is an important consideration

Break-even curve showing relation between fixed

and variable costs and profit before taxes

İlhan Konukseven ME 407 Mechanical Engineering Design 17

 MANUFACTURING COST ANALYSIS

Manufacturing organization , to remain competetive, must make its products at the minimum
cost with the required quality and function of the product

(Selecting a manufacturing technology, machines and toolings)

Cost of a product is the sum of all expenses in producing that product.

Cost Analysis is performed for two basic purposes:

1. For conventional accounting purpose (manufacturing concern is making profit or loss)
2. For decision purpose (the analysis of costs for different alternatives must be submitted
to management for decision)

Types of Costs
Fixed Costs Indirect Costs (Overhead Costs) Direct Costs
Machines Material (water, light, heating....) Man work for producing the product
Equipment and tooling Plant running men Material required for the production
(used for production & Production planning & control staff
Require certain investment) R&D staff

İlhan Konukseven ME 407 Mechanical Engineering Design 18

 Indirect Costs (Overhead Costs)

Overheads = All the costs of running the factory – Cost of direct Labour and direct material

1. Work overheads: Wages of maintenance staff, inspectors, draftsmen, storekeepers,

foremen, salaries of managers, directors, cost of cutting oil, depreciaition of machines,
heating, lighting, rents, rates

2. Office overheads: Wages of all office staff, postal, legal expenses, depreciaition of
office equipment

3. Sales overheads: Wages of all sales staff, advertising, sales commissions etc.

Direct Costs
Direct costs are attribute directly to the manufacture of a product.

There are two types of direct costs

1. Direct Material Cost: includes all the waste which has been cut away from the original
bar, casting etc.

2. Direct Labour: the time spent in manufacturing the product by the direct shop floor
worker and the wage rate.

Direct charges are proportional to the volume of production (amount produced)

İlhan Konukseven ME 407 Mechanical Engineering Design 19

 I II III
Total expenses = Fixed charges + Indirect charges + Direct charges

Fixed charges + Indirect charges + Direct charges /year

Average cost of unit = _______________________________________________
Volume of production /year

İlhan Konukseven ME 407 Mechanical Engineering Design 20

 Direct Material + Direct Labour = Prime Cost
+
Indirect Material + Indirect Labour + Fixed and Miscellaneous expenses = Factory Overhead
-Factory supplies -Supervision -Rent
-Lubricants -Inspection -Taxes
-Salary of Factory -Depreciaition
Clerks -Maintanance and repairs
-Insurance ; fire and liability
-Power
-Light
-Heat
-Small tools
-Miscellaneous factory overheads =
Cost of Goods
Manufactured
+
Distrubution Expenses + Administrative Expenses = Commertial Expenses
-Advertising -Rent
-Samples -Legal expenses
-Entertainment -Administrative and office
-Travel expenses saleries
-Rent -Telephone & telegraph
-Printing -Printing
-Postage -Miscellaneous administrative
-Telephone and telegraph expenses
-Freight
-Miscellaneous selling
expenses +
Selling Cost Salaries
and Commissions
=
Cost of Goods Sold
+
Profit
=
İlhan Konukseven ME 407 Mechanical Engineering Design 21
Selling Price
 METHODS OF DEVELOPING COST ESTIMATES

İlhan Konukseven ME 407 Mechanical Engineering Design 22

 I Fixed Charges
Money (Capital)
can be invested into a bank which earns can be invested for production of some goods
interest without any risk or damage (machines, materials and man-power)

The money invested on machines and physical facilities

for the production induces losses which can be
classified as:
A. Depreciation of the value of the physical facilities.
B. Interest of money that is paid for physical
facilities
C. Taxes and insurances to be paid for the physical
facilities.
The total monetary investment on machinery is
composed of two main elements:

Non-Recoverable Investment Recoverable Investment

- Incidental costs of testing after installation - C.I.F part in Tukey
- Cost of fabrication of fixed installations - Cost of acessories
- Cost of transportation of everything - Cost of suplimentary equipment
- Cost of installation of piping, wiring etc..

C.I.F. = Cost + Insurance + Freight

= Value on machinery + Insurance for transport + Freight + Loading of transport to the port of receivers
F.O.B. = Cost of machinery Free on Board of ship, air cargo, train . . .

İlhan Konukseven ME 407 Mechanical Engineering Design 23

 Calculating the Total Monetary Investment on a machine or equipment

Cn = Ci - C s
Net investment on Total monetary Old machine
the new machinery investment Realisable value
(initial cost) (Salvage value)
The difference between the market and the book values of any machinery or equipment is
called sunk cost

S = (Cs – Cr) - B
Book Value
Sunk cost Old machine Old machine Shown by
Realisable value Cost of removal depreciation accounts
(Salvage value)
S <= 0 loss from the sale of the old machine
S > 0 Profit from the sale of the old machine

Net investment on
the new machinery Cn = Ci – S = Ci - (Cs – Cr) + B

İlhan Konukseven ME 407 Mechanical Engineering Design 24

 A. DEPRECIATION (Amortization)

Capital equipment suffers a loss in value in time due to

- Wear
- Deterioration
- Obsolescence

A company must lay aside enough money each year to accumulate a fund to replace the
equipment.

Important aspect: depreciation can be deducted from gross profits as a cost of doing
business

Taxable income=total income – allowable expenses – depreciaition

The basic questions to be answered about depreciaition are:

1- What is time period over which depreciation can be taken

2- How should the total depreciaition charge be spread over the life of the asset

Straight Line Depreciaition: Simplest form of depreciation is taken linearly over the years

The annual depreciaition charge D is:

Initial cost - salvage cost C n  C s
D 
n n
The book value is:
Declining-Balance Depreciaition
B  C n  C n  C s 
J Sum of Years Digits Depreciaition
n Modified Accelerated Cost Recovery System

İlhan Konukseven ME 407 Mechanical Engineering Design 25

 Sum of Digits Depreciaition: The rapid technological change in machine tools out-modes the
machinery. In order to recover the investment on machines faster at earlier years of the
use the Sum of Digits Depreciaition system is used.

If the new machine has a certain critical life 6 years, the rate of depreciation receeds
according to the reverse order of the use (6,5,4,3,2,1)

D
n  J  1 C  C 
Depreciaition at the end of J years:
1  2  ..  n
n s

2  n  J  1
D C n  C s 
n( n  1)

2  1  2  ..  n  J 
The book value is: B  Cs  C n  C s 
nn  1

İlhan Konukseven ME 407 Mechanical Engineering Design 26

 Example: A numerically controlled milling machine is being puchased to replace a horizontal
boring machine. The total investment on N.C. Machine is 20,000 TL. The salvage value of
the horizontal boring machine is 1,000 TL against its book value of 900 TL. If the life of
N.C. Machine is taken 8 years and the realisable value at the end of its life is 1,200 TL.
Calculate the amount of depreciations and the book values at the end of second year of the
use of the N.C. Machine by using Linear depreciaition and sum of digits depreciation
method.
Solution: a)Linear Depreciation
Cn = Ci – S = Ci - (Cs – Cr) + B
Cn =20,000TL-(1,000TL-0)+900TL=19,900YTL

Cn  Cs 19,900YTL  1,200YTL
D D2 
8
 2,337.5TL
n
B2  C n  2  D2
B2  19,900YTL  2  2,337.5TL  15,225TL

b)Sum of Digits Depreciation Method

D
n  J  1 C  C   2  n  J  1 C  C 
1  2  ..  n n( n  1)
n s n s

2  8  2  1
D2  19,900  1,200  3,636 TL
8  (8  1)

2  1  2  ..  n  J  2  1  2  ..  6
B  Cs  C n  C s  B2  1,200  19,900  1,200  12,108 TL
nn  1 8  8  1

İlhan Konukseven ME 407 Mechanical Engineering Design 27

 B. INTEREST ON INVESTED MONEY

The invested money to purchase machinery and equipment can either be borrowed from a
bank for which an interest is to be paid, or the money invested to the machinery can be
loaned to a bank from which interest can be earned. Hense the interest is the natural
part of the cost of the product as fixed charges.

C. TAXES AND INSURANCES ON INVESTMENT AND ASSETS

Taxes are an important factor to be considered in engineering economics decisions.

Likewise to the interest on investment on machinery and physical facilities, taxes are to
be paid to the State at a certain rate of the value of assets, the physical facilities must
be insured against any type of risk or damage (fire, theft, natural hazards...) The rate
of taxes and the insurances are determined by State and insurance companies
respectively.

The yearly taxes and insurances are paid on the book value of machinery and physical
facilities.

Some of the tax types are:

Property taxes: Based on the value of the property owned by the corporation
(land, buildings, equipment, inventory)
Sales taxes: Imposed on sales of products. Usually paid by customer.
Excise taxes: Imposed on the manufacture of certain products like tobacco and
alcohol. Usually passed on the customer.
Income taxes: Imposed on corporate profits or personel income.

İlhan Konukseven ME 407 Mechanical Engineering Design 28

 II Indirect Costs (Overhead Costs)
The sum of fixed and indirect charges for the complete manufacturing organization is called
overheads. (non-productive labour: designers, office personel including managers, plant
running, maintenance, transport people etc.) (non-productive material: materials for services
and plant, spare parts of machinery and services)

If the manufacturing organization is occupied by a variety of products, the overheads must

be distributed to the different products correctly in order to reflect the true cost. False
distribution of overheads gives false idea cost and profittability on products to the
management.

Different methods of distribution is used for different types of production

Direct Method:
If the contribution of overhead charges on to the cost of unit product is proportional to the
direct material used or produced (continuous production, stell bars and strips, . . ) this
method is most suitable.
H = The total overheads per year in YTL.
Rdm = Overhead rate in TL. per TL. of direct material,
Cdm = Total direct material expenses in TL. per year,
H
Rdm  TL / TL of direct material
C dm
Rdm = Overhead rate in TL. per Kg. of direct material,
W = Total weight of direct material in Kg. per year,
H
Rdm  TL / Kg. of direct material
W
İlhan Konukseven ME 407 Mechanical Engineering Design 29
 Example:
A brass mill is producing 2000 tons of various shapes and sized milled brass
per year. The total overheads are 4,000 TL/year. Calculate the overhead
rate, if the production of 20mm round bars is 500 tons/year, calculate the
overhead contribution to 20 mm round bars.

Solution:

Overheads = 4,000 TL/year

Total weight of direct material = 2000 tons/year
4,000
Overhead rate: Rdm   2.00 TL/ton
2000
H= 2.00 x 500 = 1,000 TL/year

If the total cost of production of 20mm diameter bars is required:

Overhead Cost
for 20mm round bars
Overhead rate

C tot  C dm  Rdm  C dm  C dl
Total cost of Total direct Total direct Total direct
production material expenses material labour expenses

İlhan Konukseven ME 407 Mechanical Engineering Design 30

 2. Unit Production Method:
If an organization is producing several types of similar products in mass; if each type of
unit product is consuming nearly equal amount of labour and material but the volume of
production of each type is differing from the others over the year, the overheads can be
distributed to each type of product according to the unit production method.

H : The total overheads per year in TL.

N = N1 + N2 + .... +Nn : the total number of products of all types per year

Rp : overhead rate in TL per piece

H
Rp   TL / piece
N 1  N 2  ..  N n

The unit product price:

Overhead rate/piece

 
C tot / piece  R p / p  C dm / p  C dl / p TL/piece

Total cost of Total direct Total direct

Production/piece material expenses labour expenses
/piece /piece

İlhan Konukseven ME 407 Mechanical Engineering Design 31

 3. Direct Labour Method:

This method assumes that the overhead expenses in production are proportional
to direct labour cost. It is simple and provides accurate results where the labour
is main productive element and the wages are fairly uniform.

A good example to this method is the watch making (electronics) industry where
all the people are fully skilled, the material cost is small and there is fair
amount of automation.

H : The total overheads per year in TL.

Cdl(total) : total direct labour in TL. per year

Rdl : overhead rate in TL, for each TL direct labour

H
Rdl   TL / piece
C dl ( tot )
Overhead rate
The cost of unit product:

C tot / piece  C dm / p  C dl / p  C dl / p  Rdl  C dm / p  C dl/p  1  Rdl  TL/piece

Total cost of Total direct Total direct

Production/piece material expenses labour expenses
/piece /piece

İlhan Konukseven ME 407 Mechanical Engineering Design 32

 4. Direct Labour Hour Method:

In this method it is assumed that the overhead expenses are proportional to the
number of man-hours directly consumed on manufacturing each item.

A good example of this type of production is the manufacture of machine tools,

quality inspection tool and equipment.

H : The total overheads in TL per year.

T : total hours of direct labour for all products per year

T  T1  T2  ....  Tn
Rdlh : overhead rate per hour of direct labour

H H
Rdlh   TL / piece
T1  T2  ...  Tn T

The unit cost of a product: Overhead rate

Ctot / piece  Cdm / p ( 2 )  Cdl / p ( 2 )  Rdlh  T2 /P2 TL/piece

Total cost of Total direct Total direct

Production/piece material expenses labour expenses
/piece /piece

İlhan Konukseven ME 407 Mechanical Engineering Design 33

 5. Machine Hour Method:

Large manufacturing enterprises are occupied in production of large diversity and variety of
products in different departments or production units.
Each production unit or department makes different contribution to the earnings of the
company.

There are three steps:

1.The total overhead expenses (Htot) are distributed to each productive department of plant
according to the benefit each department contribute to the earning of the company.
Overhead of department (1) H 1  Cn1  H tot
where Cn1  Cn2  ...  Cnn  1
2.The share of overhead charge in each department is distributed to each machine on the
basis of the contribution of each machine to the production (how long each machine works,
what is the percentage cost of the item that is made on the machine etc.) Overhead of the
first department is distributed to machines:
H 1  Cn1m1  H 1  Cn1m 2  H 1  ....  Cn1mn  H 1  C n1  H tot
where Cn1m1  Cn1m 2  ...  Cn1mn  1
3.Several types of works are made on each machine at each department. The overhead
share of each machine must be distributed again to each type of work according to the
machine hour that is consumed in making the type of work in question.The fourth machine in
the first department:
Cn14  T1 Cn14  T2 Cn  T
H 14  Cn14  H 1    ....  14 n
T T T
The machine times sum up T1  T2  ...  Tn  T

İlhan Konukseven ME 407 Mechanical Engineering Design 34

 6. Space Rate Method:

The distribution of overhead charges by this method is applicable in “Single production to

order” system of manufacturing, such as ship building, heavy industrial equipment
manufacturing to the order. In this method, the amount of space occupied by a machine or
a product has an evident relationship to the distribution of overhead charges.

In some cases, only one of the methods mentioned before can be sufficient for effective
distribution of overheads. But at many cases and instances, the combination of more than
one method may solve the problem.

İlhan Konukseven ME 407 Mechanical Engineering Design 35

 III Direct Charges
Direct charges are born through the labour and material directly involved for
production.

There are two main sources of direct charges:

a) Direct material
b) Direct Labour

a) Direct Material

The material can be purchased as;

- a unit of number of unfinished or semi-finished item
- a unit of weight of raw or bar material

In case of purchasing the unit of price (as cast or forged articles):

Total Direct C dm  C um  N TL./year

Material Charge
Direct Material Number of Products
Cost of Unit Product Produced Per Year
If the direct material is purchased in bar , powder or bulk form by weight)

Total Direct C dm  C wm  Wu  N TL./year

Material Charge
Number of Products
Direct material Weight of Material
Produced Per Year
Cost YTL/kg Necessary for each
Product kg/piece
İlhan Konukseven ME 407 Mechanical Engineering Design 36
 b) Direct Labour

To produce one final product requires man-power (Tm). This can be called the
work content of the product and is calculated by various work study methods. It
involves estimating the loading, unloading, approach and withdrawal times;
machining, forming, assembly times and so on.

The direct labour rating varies with the quality of workmanship at different
stages of the work.

Labour ratings at different levels as

C dl 1 , C dl 2 , C dl 3 ,......
Work content of these levels
Tm1 , Tm 2 , Tm 3 ,.....
Total direct labour charge:
C dl  C dl 1  Tm1  C dl 2  Tm 2  .....  C d ln  Tmn   N TL./year
Work Content:
Tm1  Tm 2  Tm 3  ....  Tmn  Tm
Total Labour hour required per year for the production of (N) items:

Tm  N

İlhan Konukseven ME 407 Mechanical Engineering Design 37

 MAINTENANCE CHARGES

Maintenance means maintaining or keeping the facility in efficient running condition,

Therefore it is the part of indirect expenses.

A good and efficient maintenance requires the following procedures:

a) The time of maintenance of different machines at different level must be correct and
appropriate.
b) The stock of maintenance material and spare parts must be at appropriate level neither
to starve the maintenance, nor to put the extra un-warranted financial burden on
production.

The maintenance is carried out in three distinct form:

a) Daily routine maintenance. Daily, weekly or periodic cleaning and changing the oil and
greasing

b) The change of parts which are worn or liable to failure (without waiting them to fail)
This is called preventive maintenance.

c) Repairs machinery when failure occurs expectedly or unexpectedly. This will of course,
cause the production to stop. Dangereous, particularly in flow type of production.

İlhan Konukseven ME 407 Mechanical Engineering Design 38

 Either for timing or for stock control maintenance, the scientific tools are used:

a) A sound knowledge on statistic and probability

b) A sound knowledge on operational research, particularly on queueing and simulation

techniques.

c) Having a technological knowledge and experience on maintenance.

When a machinery is new, the maintenance charges are low. But, as the machinery and
parts of it wear off, the replacement and keep-up expenses start increasing, and hence
the maintenance charges increase due to both labor and material.

The maintenance expenses of any facility increases with the time of use.

If the increase taken linear with the time, the maintenance charges at any year can be
formulated in the following equation;
Time in years

M J  M 0  rm  J TL
Maintenance
Expenses at year J Initial (fixed) Rate of increase
Maintenance of Maintenance
Expenses Expenses

If the maintenance charges does not increase linearly

but steeps up as the years pass M J  M 0  rm  J 2 TL

İlhan Konukseven ME 407 Mechanical Engineering Design 39