Cost Concepts &

Design Economics
 STANDARD COSTS
 planned costs per unit of output that are established in
advance of actual production or service delivery
 develop from anticipated direct labor hours, materials,
and overhead categories
 Typical use
❖ estimating future manufacturing costs
❖ Measuring operating performance by comparing
actual cost per unit with the standard unit cost
❖ preparing bids on products or services requested
by customers
❖ establishing the value of work in process and
finished inventories
COST CLASSIFICATION FOR PREDICTING
COST BEHAVIOR

 Cost behavior
describes how a cost item will react or
respond to changes in the level of
business activity

Classifications:
Fixed Costs
Variable Costs
Incremental Costs
 FIXED COSTS
Cost that are unaffected by changes in activity
level over a feasible range of operations for the
capacity or capability available. Typical fixed
costs include
- insurance and taxes on facilities,
- general management and administrative
salaries,
- license fees, and
- interest costs on borrowed capital.
VARIABLE COSTS
Costs associated with an operation that
varies in total with the quantity of output or
other measures of activity level.

Examples of these costs are the costs of

materials and labor used in a product or
service.
 INCREMENTAL COSTS (INCREMENTAL
REVENUE)
- the additional cost (or revenue) that results
from increasing the output of a system by one
(or more) units

- this cost is often associated with “go – no

go” decisions that involve a limited change in
output or activity level
COST CONCEPTS RELEVANT TO
DECISION MAKING

Costs are an important feature of many

business decisions. In making decisions,
it is essential to have a firm grasp of the
concepts of differential cost, opportunity
cost, and sunk cost.
 DIFFERENTIAL COST
refers to those cost which arise as the
result of a change in operations or policy.
Thus, differential cost may also be
considered as synonymous with
increment cost.
OPPORTUNITY COST
 potential benefit that is given up as you
seek an alternative course of action.
 It is incurred because of the use of
limited resources, such that the
opportunity to use those resources to
monetary advantage in an alternative
use is foregone. Thus, it is the cost of
the best rejected (foregone) opportunity
and is often hidden or implied.
SUNK COST

 cost that has occurred in the past and

has no relevance to estimates of future
costs and revenues related to an
alternative course of action.
 involves a past expenditure that cannot
be recovered, or capital that has already
been invested and cannot be retrieved.
Life Cycle Cost

 summation of all the costs related to a

product, structure, system, or service
during its life span.

 It begins with identification of the

economic need or want (requirement)
and ends with retirement and disposal
activities
Category of Life Cycle Cost
 Investment cost is the capital required for
most of the activities in the acquisition
phase. This cost is also called a capital
investment.

 Working capital refers to the funds required

for current assets that are needed for the
start-up and support of operational
activities. The amount of working capital
needed will vary with the project involved,
and some or all of the investment in working
capital is usually recovered at the end of a
project’s life.
Category of Life Cycle Cost
 Operation and Maintenance cost (O&M)
include many of the recurring annual expense
items associated with the operation phase of
the life cycle. The direct and indirect costs
of operation associated with the five primary
resource areas – people, machines, materials,
energy, and information – are major part of
the costs in this category.

 Disposal cost includes those nonrecurring

costs of shutting down the operation and the
retirement and disposal of assets at the end
of the life cycle.
The General Economic Environment
The goods and services that are produced and utilized
may be divided conveniently into two classes.

 Consumer goods and services - those products or

services that are directly used by people to satisfy
their wants. Food, clothing, homes, cars, television
sets, haircuts, medical services are examples.
 Producer goods and services - used to produce
consumer goods and services or other producer
goods. Machine tools, factory buildings, buses,
farm machinery are examples. The amount of
producer goods needed is determined indirectly by
the amount of consumer goods or services that are
demanded by people.
The General Economic Environment

p = a – bD
Price

Units of Demand
BREAK-EVEN ANALYSIS

 Evaluation method employ to determine

the point where revenues and expenses
are equal which serve as an indicator for
businessman/investors/financiers to
know at what level of business activities
they will be able to recover their
capitals.
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,

Total Revenue = price x demand

TR = pD
TR = (a – bD)D
TR = aD – bD2
COST, VOLUME, AND BREAKEVEN
POINT RELATIONSHIPS

 Fixed costs remain constant over a wide

range of activities, but variable costs
vary in total with the volume of output.
Thus, at any demand D, total cost is

CT = C V + C F

where CF and CV denote fixed and variable

costs, respectively.
COST, VOLUME, AND BREAKEVEN
POINT RELATIONSHIPS

 For the linear relationship assumed here,

CV =cv*D,

where cv is the variable cost per unit.

SCENARIO 1: Demand as a
function of price

Demand
SCENARIO 1: Demand as a
function of price
 When total revenue and total cost are
combined, the typical results as a function
of demand are depicted in the figure. At
breakeven point D1', the 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. At breakeven point
D2', total revenue and total cost are again
equal, but additional volume will result in
an operating loss instead of a profit.
SCENARIO 1: Demand as a
function of price
Profit (Loss) = Total Revenue – Total Costs
= (aD – bD2) – (CV + CF)
= (aD – bD2) – (cvD + CF)
= –bD2 + (a – cv)D - CF
SCENARIO 1: Demand as a
function of price
 In order for a profit to occur and to
achieve the typical results depicted in
the figure, two conditions must be met:
1. the price per unit that will result in no
demand has to be greater than the
variable cost per unit. (This avoids
negative demand.)
2. Total revenue must exceed total cost for
the periods involved.
SCENARIO 1: Demand as a
function of price
 If these conditions are met, we can find
the optimal demand at which maximum
profit will occur by taking the first
derivative of equation of a profit with
respect to D (demand) and setting it
equal to zero
𝑑 profit
= 𝑎 − 𝑐𝑣 − 2𝑏𝐷 = 0.
𝑑𝐷
 The optimal volume D that maximizes
profit is 𝑎 − 𝑐𝑣
∗
𝐷 =
2𝑏
SCENARIO 1: Demand as a
function of price
 To ensure that we have maximized
profit (rather than minimized it), the
sign of the second derivative must be
negative.
𝑑2 profit
2
= −2𝑏,
𝑑𝐷
SCENARIO 1: Demand as a
function of price
 An economic breakeven point for an
operation occurs when total revenue
equals total cost. Therefore, at any
demand D,

Total revenue = Total cost

aD – bD2 = cvD + CF
-bD2 + (a – cv)D – CF = 0
SCENARIO 1: Demand as a
function of price
 Since it is a quadratic equation with one
unknown (D), we can solve for the
breakeven points D1' and D2' (the roots of
the equation):

− 𝑎 − 𝑐 ± 𝑎 − 𝑐 2 − 4 −𝑏 −𝐶
′ 𝑣 𝑣 𝐹
𝐷=
2 −𝑏
 Sample Problem
A company produces an electronic timing switch that is
used in consumer and commercial products. The fixed
cost is Php730,000 per month, and the variable cost is
Php830 per unit. The selling price per unit is p=1800 –
0.2D. For this situation,
a. Determine the optimal volume for this product and
confirm that a profit occurs (instead of a loss) at this
demand.
b. Find the volume at which breakeven occurs; that is,
what is the range of profitable demand?
 Solution
a. Profit = 𝑇𝑜𝑡𝑎𝑙 𝑅𝑒𝑣𝑒𝑛𝑢𝑒 − 𝑇𝑜𝑡𝑎𝑙 𝐶𝑜𝑠𝑡
= 𝑝𝐷 − 𝐶𝐹 + 𝑐𝑣 𝐷
= 1800 − 0.2𝐷 𝐷 − 730,000 + 830𝐷
= 1800𝐷 − 0.2𝐷2 − 730,000 − 830𝐷
Profit = −0.2𝐷2 + 970𝐷 − 730,000

 Taking the first derivative of the equation and equating it to zero:

𝑑 Profit
= −0.4𝐷 + 970 = 0
𝑑𝐷
−0.4𝐷 = −970
−970
𝐷= = 𝟐, 𝟒𝟐𝟓 𝐮𝐧𝐢𝐭𝐬
−0.4

 To confirm that a profit occurs, instead of a loss, we take the

second derivative of the profit equation:
𝑑 2 profit
= −0.4 ,
𝑑𝐷 2

Since the second derivative is negative (-), then the profit is

maximized at 2,425 units.
 Solution

′ −970± 970 2 −4 −0.2 −730,000

b. 𝐷 =
−2 0.2

𝑫′𝟏 = 𝟗𝟑𝟏. 𝟒𝟕 and 𝑫′𝟐 = 𝟑, 𝟗𝟏𝟖. 𝟓𝟑

Thus, the range of profitable demand is 931.47 to

3,918.53 units per month.
SCENARIO 2: Price is
Independent of Demand
Assumptions for Break-even analysis
 All units produced are sold at a constant
price per unit.
 There is no income other than that from
operations.
 The variable costs are directly proportional
to production rate from zero to 100%
capacity.
 Fixed costs are constant regardless of the
number of units produced.
Break-even Point (BEP) Formula

𝐶𝐹
𝑄𝐵𝐸𝑃 =
𝑝 − 𝑐𝑣
where:
QBEP = production quantity (volume) at which
break-even will occur
CF = fixed costs
p = selling price per unit
cv = variable cost per unit
Sample Problem
A firm has the capacity to produce 1,000,000 units of a
product per year. At present, it is able to produce and sell
only 600,000 units yearly at a total revenue of
Php720,000. Annual fixed costs are Php250,000 and the
variable costs per unit are Php0.70.
 Calculate the firm’s annual profit or loss for this
production.
 How many units should be sold annually to break-
even?
 If the firm can increase its sales to 80% of full capacity,
what will its profit or loss be, assuming that its selling
price and variable cost per unit remain constant?
 Draw a break-even chart indicating the above results
on the chart.
 Problem Details & Computation

a.) Profit = Total Revenue - Total Cost

= Php720,000 -[Php250,000 + 0.70(600,000)]
= Php50,000
 b)

Computing for p =

Total Revenue Php720,000

= = Php1.20 per unit
Q 600,000 units

Php250,000
QBEP = = 500, 000 units
(Php1.20 - Php0.70) per unit
c. At 80% capacity (800,000 units per year)
Profit = Total revenue – Total costs
Profit = (800,000 x Php1.20/unit) – [Php250,000 +
(Php0.70/unit x 800,000)]
Profit = Php960,000 – Php810,000
Profit = Php150,000
Sample Problem

 An engineering consulting firm measures its output in a standard

service hour unit, which is a function of the personnel grade levels in
the professional staff. The variable cost is Php620 per standard
service hour. The charge-out rate is Php855.60 per hour. The
maximum output of the firm is 160,000 hours, and its fixed cost is
Php20,240,000 per year. For this firm,
a. What is the break-even point in standard service hours and in the
percentage of total capacity?
b. What is the percentage reduction in the break-even point if fixed
costs are reduced by 10%?
c. What is the percentage reduction in the break-even point if the
variable costs per hour is reduced by 10%?
d. What is the percentage reduction in the break-even point if the
selling price per unit is increased by 10%?
 CF 20, 240, 000
a. QBEP = = = 85,908.32 hours
p − cv 855.60 − 620
85,908.32 hours
% capacity = = 0.5369
160, 000 hours
Or their BEP is 53.69% of their annual capacity.
 EXERCISE
1. A manufacturer produces certain items at a labor
cost per unit of Php315, material cost per unit of
Php100, variable cost of Php3 each. If the item has a
selling price of Php995, how much units must be
manufactured each month for the manufacturer to
break-even even if the monthly fixed cost is
Php461,600.

2. General Electric Company which manufactures

electric motor has a capacity of producing 150 motors a
month. The variable costs are Php4,000 per month, the
average selling price of the motor is Php750 per motor.
Fixed costs of the company amount to Php78,000 per
month which includes all taxes. Determine the number
of motors to be produced per month to break-even.
3. A telephone switchboard 100 pair cable can be made
up with either enameled wire or tinned wire. There will
be 400 soldered connections. The cost of soldering a
connection on the enameled wire will be Php1.65, on the
tinned wire, it will be Php1.15. A 100-pair cable made
up with enameled wire cost Php0.55 per lineal foot and
those made up to tinned wire cost Php0.75 per lineal
foot. Determine the length of cable run in feet so that
the cost of each installation would be the same.

4. The purchase of one of two 500 hp motors A and B is

better considered. Motor A costs Php10,000 and
Php2,000 to install. Motor B costs Php12,000 and
Php3,000 to install. Motor A is 90% efficient, with
Php100 annual maintenance. Motor B is 92% efficient
with Php200 annual maintenance. Fixed charges are 15%
and energy cost Php7.46 an hour to run the less
efficient motor. Fixed charges are based on installed
cost of motors. Determine the break-even point in hours
of use per year. If the actual hours of use per year is
estimated as 3000, which motor would you recommend?