ECONOMIC DECISION

ANALYSIS IN CONSTRUCTION

Dr Zahoor
 Course topics and schedule
Week Topic Reading

Introduction, Study Skills , Engineering Economics, Decision Making

1 Chapter 1
Process
2 Cost Concept Chapter 2
Chapter 18,
3 Accounting systems, Balance Sheet, Income sheet
Handouts
4 Time value of Money Chapter 3

5 Interest and Equivalence Chapter 2

7 Rate of Return Chapter 7

8 Deprecation Chapter 11

9 Profit Centre Analysis Hand outs

10 Financial Analysis Chapter 8,9

11 Cash Flow Analysis Chapter 12

12 Benefit Cost Analysis Chapter 9

13 Financing Chapter 16

14 Financial Decision Making Chapter 17

15 Project Presentations

16 Final Exam
 ENGINEERING COSTS
COST? EXPENSE?

•Use of company resources (such as •Part of Cost which is “used up” for purpose
cash or cash-equivalent value) to provide of generating revenue
future company benefit
Example
•Measured by resource given up
 Buy Equipment for $2,000 (Life=4 years)
Example
Cost = $2,000
 Buy Equipment for $2,000,
 Expense = $500 per year (As life is 4
Cost = $2,000
years)
 Future benefit = Use of equipment
 ENGINEERING COSTS
Evaluating a feasible alternative requires
that various costs be analyzed:- TYPES OF COSTS

• Initial investment • Direct and Indirect

• New construction • Fixed and Variable

• Facility modification • Marginal and Average

• General labor • Sunk and Opportunity
• Parts and materials • Recurring and Non-Recurring
• Inspection and quality • Incremental
• Fixtures and tooling • Cash and Book
• Data management • Life-Cycle
• Technical support
 ENGINEERING COSTS

Direct costs Indirect costs

• Costs that can be • Costs that cannot be easily
easily and conveniently and conveniently traced to
traced to a unit of product or a unit of product or other
other cost object.
cost object.
• Examples: direct material
and direct labor • Examples: manufacturing
overhead….office supplies

5
 ENGINEERING COSTS

Direct Costs: Indirect Costs: Costs of the product not

physically and conveniently traceable.
Direct costs come from activities directly
associated with the final product or service
produced and can be easily traced. Indirect Material (Glue/ sand paper used
for a single chair manufacturing, machine
Direct Material and Direct labor Costs are depreciation etc)
easily traceable to a product Indirect Labor (Administrative /
management staff salary etc)
Example: Receiving/Shipping areas of a manufacturing plant are used
by all incoming materials & all outgoing products. Materials & products
differ in their weight, size, fragility, value, number of units, packaging &
so on, & the receiving & shipping costs depend on all these factors.
Also, different materials arrive together & different products are shipped
together, so these costs are intermingled & often cannot be tied directly
to each product or material.
 Product Costs in Manufacturing
• Direct Materials (direct cost) – materials that are physically

and conveniently traced to the product being made

• Direct Labor (direct cost)– labor costs of employees that are

physically and conveniently traced to the product being made

•Example: Charges of carpenter

• Manufacturing Overhead (indirect cost) – all other costs of

the product not physically and conveniently traced to the

product.
7
Examples of Manufacturing Overhead Costs

• Indirect Materials – materials that are part of a product, but

the costs are not easily or conveniently traced to the product.

Amount of glue and sand paper used in making a chair

• Indirect Labor – labor costs of a product that are not easily or

conveniently traced to the product. Cost of various people such

as for supervisors, material handlers, design engineers

• Other Factory or Production Costs such as utilities,

depreciation, insurance, etc. 8

Cost Classifications for Predicting Cost Behavior

9
 Total Variable Cost
Your total mobile network telephone bill is based on how
many minutes you talk.
The total bill varies with the number of minutes used
Total Long Distance
Telephone Bill

Minutes Talked
10
 Variable Cost Per Unit
Variable costs change in total as the activity level rises and falls,
variable cost per unit is constant. Cost per long distance
minute talked is constant.
For example, 10 cents per minute.

Telephone Charges
Per Minute

11
Minutes Talked
 Total Fixed Cost
Total fixed cost is constant within the relevant range.
Your monthly basic telephone bill probably does not change
when you make calls on PTCL nos.
Telephone Bill
Monthly Basic

Number of PTCL Calls

12
 Fixed Cost Per Unit
On a per unit basis, a fixed cost is inversely related to activity.
Average fixed cost per local call decreases as more local
calls are made.

Monthly Basic Telephone

Bill per Local Call

Number of Local Calls

13
 Engineering Costs

Marginal - variable cost for the next unit (i.e. one more unit)

• Depends on the next unit

Average - total cost / number of units

• [Rent+ food+…+n] / number of units

14
15
Engineering Costs and Cost Estimating
Example 2-1. Albert’s Charter Bus Venture
Albert plans to charter a bus to take people to see a wrestling match
show in Jacksonville. His wealthy uncle will reimburse him for his
personal time, so his time cost can be ignored.

Item Cost Item Cost

Bus Rental $80 Ticket $12.50
Gas Expense $75 Refreshments$ 7.50
Other Fuel Costs $20
Bus Driver $50

Total Costs $225.00 Total Costs $20.00

• Which of the above are fixed and which are variable costs?
• How do we compute Albert’s total cost if he takes n people to
Jackonville?
16
Albert’s Charter Bus Venture (example)

• Answer: Total Cost = $225 + $20 n.

Graph of Total Cost Equation:

Total cost

17
 Albert’s Charter Bus Venture (example)
Marginal cost (marginal tax)
-The cost to take one more person
Average cost
- Average cost: the cost per person
Avg. Cost = TC/n i.e. [total cost / n]
Avg. Cost = ($225+$20n)/n

– For n = 30, TC = $885

Avg. Cost = $885/30 = $29.50

Total cost cannot be calculated

from an average cost value

For n =35, TC  35*($29.50) = $ 1,032.50 18

 Albert’s Charter Bus Venture (example)
Marginal and Average Costs

$300.00

$250.00

$200.00
Average
Cost

$150.00 Marginal
Trip Ticket
$100.00

$50.00

$0.00
1 3 5 7 9 11 13 15 17 19 21 23
19
Number of People
20
 Albert’s Charter Bus Venture (example)
Question: Do we have enough information yet to decide how much money
Albert will make on his venture? What else must we know?
– Albert needs to know his total revenue

– Albert knows that similar ventures in the past have charged $35 per
person, so that is what he decides to charge

– Total Revenue = 35n (for n people)

Total profit = Total Revenue – Total Cost
= 35n – (225 + 20n) = 15n – 225
Question:
How many people does
Albert needs to break even?
(not lose money on his venture)

Solve 15 n – 225 = 0 => n=15

21
more than 15, he makes money
 Albert’s Charter Bus Venture (example)
Where is the Loss Region? Where is the Profit Region? Where is the
Breakeven point? Can you make this chart in Excel?

22
 Sunk Cost
A sunk cost is money already spent due to a past decision.
– As engineering economists we deal with present and future
opportunities
– We must be careful not to be influenced by the past
– Disregard sunk costs in engineering economic analysis
Example:
Suppose that three years ago your parents bought you a laptop
PC for $2000.
– How likely is it that you can sell it today for what cost?
– Suppose you can sell the laptop today for $400. Does the
$2000 purchase cost have any effect on the selling price
today?
The $2000 is a sunk cost. It has no influence on the present
23
opportunity to sell the laptop for $400.
 Opportunity Cost
• An opportunity cost is the benefit that is foregone by engaging
a business resource in a chosen activity instead of engaging
that same resource in the foregone activity.

• Example: Suppose your wealthy uncle gives you $75,000 when

you graduate from high school. It is enough to put you through
college (5 years at $15,000 per year).
It is also enough for you to open a business making web pages
for small companies instead of going to college. You estimate
you would make $20,000 per year with this business.

– If you decide to go to college you give-up the

opportunity to make $20,000 per year
– Your opportunity cost is $20,000
– Your total cost per year is $35,000 24
 Sunk and Opportunity Cost
Example. A distributor has a case of electric pumps. The pumps
are unused, but are 3 years old. They are becoming obsolete.
Some pricing information is available as follows.

Item Amount Type of Costs

25
 Recurring and Non-Recurring Costs
Recurring costs are those expenses that are known, anticipated,
and occur at regular intervals. These costs can be modeled as
cash flows.

Non-recurring costs are one-of-a-kind and occur at irregular

intervals. They are difficult to plan for or anticipate.

• Example. You decide to landscape a ground and then care for

it. Which are recurring and which are non-recurring costs you
incur?

26
 Recurring and Non-Recurring Costs
How a cost will react to changes in the level of activity within the relevant range

Examples
Non-Recurring Costs
Remove existing trees, vegetation: This is typically a one-time cost unless you need
to remove additional trees or vegetation later.
Have land graded with bulldozer: Grading the land is usually a one-time cost unless
major changes are needed in the future.
Have yard planted with grass: The initial planting of grass is a one-time cost unless
you need to reseed or replant in the future.
Plant shrubs, trees: Planting shrubs and trees is generally a one-time cost unless you
decide to add more or replace existing ones.
Recurring Costs
Mow grass: This is a recurring cost, as you'll need to mow the grass regularly to
maintain its appearance.
It's important to note that while the initial planting and landscaping activities involve
one-time costs, ongoing maintenance activities like mowing, fertilizing, watering, and
pest control are considered recurring costs. These recurring costs are necessary to
ensure the continued health and aesthetic appeal of the landscaped area.
 ENGINEERING COSTS
How a cost will react to changes in the level of activity within the relevant range
 Incremental Cost
• Incremental Cost is the additional cost that results from:
– Increasing the output of a system by one (or more) units
– Selecting one alternative over another
Example: Philip can choose between model A ( a budget model) or
model B (with more features). The following information is available.
Cost Items Model A Model B Incremental
Cost of B

Purchase price $10,000 $17,500 $7,500

Installation cost $3,500 $5,000 $1,500
Annual maintenance cost $2,500 $750 $-1,750/yr
Annual utility expense $1,200 $2,000 $800/yr
Disposal cost after useful life $700 $500 $-200
 Cash Costs vs. Book Costs
Cash costs
require the cash transaction of dollars from “one pocket to
another”.
Book costs
are cost effects from past decisions that are recorded in the
books (accounting books) of a firm
– Do not represent cash flows

– Not included in engineering economic analysis

– One exception is for asset depreciation (used for tax

purposes).

Example: You might use Edmond’s Used Car Guide to conclude

the book value of your car is $6,000. The book value can be
thought of as the book cost. If you actually sell the car to a 30
friend for $5,500, then the cash cost to your friend is $5,500.
 Life-Cycle Costs

Life-cycle costs are the summation of all costs, both

recurring and nonrecurring, related to a product,
structure, system, or service during its life span

Products go through a life cycle, just like people

– Assessment & Justification Phase

– Conceptual or Preliminary Design Phase
– Detailed Design Phase
– Production or Construction Phase
– Operational Use Phase
– Decline and Retirement Phase
31
Life-Cycle Costs - Committed & Spent
Life Cycle Cost Chart
% Total L.C. Cost

120.00%
100.00% L.C. costs
80.00% committed
60.00%
40.00% L.C. costs
20.00% spent
0.00%

Project Phase 32
Life-Cycle Costs - Committed & Spent

33
Life-Cycle Design Cost

34
Life-Cycle Costs

35
 Life-Cycle Costs
Comments:
• The later design changes are made in the life-cycle, the
higher the costs.
• Decisions made early in the life-cycle tend to “lock in” costs
incurred later in the life cycle:

Nearly 70 to 90% of all costs are set during the

design phases, while only 10 to 30% of the cumulative life-
cycle costs have been spent.

• Question. When is the best time to consider all life-cycle

effects, and make design changes?

• Bottom Line. Engineers should consider all life-cycle

costs when designing products and the systems that 36
produce them.
 ENGINEERING COSTS
How a cost will react to changes in the level of activity within the relevant range

Example: You might use “Used

Car Guide” to conclude the book
value of your car as $6,000. Book
value can be thought of as the
Can we conclude that book cost. You actually sell the car
model B is more expensive for $5,500, then the cash cost to
than model A? buyer is $5,500.
 COST ESTIMATION
Engineering Economic Analysis focuses on the estimated future consequences of
current decisions. Reasonable analysis thus require careful estimates. The aspect of
estimating that makes it difficult are; One of a kind of estimate, time and effort
available, and estimator expertise.
TYPES OF ESTIMATES

Rough Estimates Semi Detailed Estimates Detailed Estimates

•For high-level planning •Used for budgeting • Used during a project’s detailed
design & contract bidding phases
(general feasibility purposes at project's
• Made from detailed quantitative
activities) conceptual or preliminary
models, blueprints, product
•Involve back-of-the- design stages
specification sheets & vendor
envelope numbers with •More detailed, and quotes
little detail/accuracy require additional time • Involve most time & resources to
•Require minimum and resources to develop develop & are much more accurate

resources to develop •Accuracy is generally • Accuracy is generally

•Accuracy is generally -3% to +5%

-15% to +20%
 COST INDICES
A cost index may refer to a measure used to track the changes in the
cost of a basket of goods & services over time.
•Govt of Pakistan publishes cost index data through the State Bank of Pakistan.

•The best-known example is the consumer price index (CPI), a measure of

inflation.

– The measure is scaled, so it is only the relative values of any two

measures that are meaningful.

– For example, in 1920, the measure was about 20; in 1997 it was about
160. The conclusion is that one would have to spend 160/20, or 8 times
as much in 1997 as in 1920 for the same consumables.

• Cost indices work in the same way as price indices.

• Cost indices are dimensionless. 39

 ESTIMATION MODELS
PER UNIT MODEL: Uses a "per unit" factor, SEGMENTING MODEL: Estimate is
such as cost per square foot, to develop the decomposed into its individual components,
estimate desired (Service/Customer, Gasoline estimates are made at those lower levels, &
cost per mile, construction cost per square ft then the estimates are aggregated (added)
back together
EXAMPLE: Estimate the cost per student that you will incur for hosting 24 foreign
students at a camp for 10 days with activities (2 x day canoeing, 3 x camp-site hikes,
3 x lake games, and Nightly entertainment).
• $ 50/15 persons + gas: Van rent to camp Living Cost : $3240
(one way) Meals for 10 x days:
• Camp at 50 miles 24 campers x $10/camper/day x 10 days = $ 2400/-
Cabin rent:
• Van does 10 miles per gallon
24 campersx1 cabin/4campers x $10/day/cabin x10 days= $600/-
(gas is $1 per gallon)
Overhead: 24 campers x $1/day/camper x 10 days = $240/-
• $ 10 per Cabin per 4 x Camper per day
• $10 Meals per Camper Entertainment Cost : $410
• $ 2 Boat per Camper to Island (one way) Day hike: 24 x campers x 3 day hike x $2.5/camper/day hike=$180/-
• $1 Overhead per Camper Cabin rent:24 campersx1 cabin/4campers x $10/day/cabin x10 days=
• $2.5 Day hike per Camper $240/-

Transportation Cost : $316

Van: 2 x vans x 2 trips x ($50/van +50miles x Total Cost=Tpt Cost+Living Cost+Entertainment Cost=$3966
1 gal/10 miles x $1/gal) = $220/-
Boat: 2 trips x $2 /Camper x 24 Campers = $96 The Cost per student would be $3966/24= $165.25

The overall estimate was segment into the costs for travel, living, and
entertainment. The sub-estimates were made using the unit factor model
 ESTIMATION MODELS
COST INDICES: These are numerical values that reflect historical change in engineering
(and other) costs. These are dimensionless, and reflect relative price change in either
individual cost items (labor, material, utilities) or groups of costs (consumer prices,
producer prices).
Cost at time A Index value at time A
=
Cost at time B Index value at time B

Example: Mr X is interested in estimating the annual labor and material costs for a new
production facility. He was able to obtain the data, as: Labor cost index was 124, ten
years ago and now 188. Annual labor cost for a similar facility was $ 575,500, ten years
ago. Material cost index value was 544, three years ago and is 715 now. Annual
material cost for a similar facility was $ 2455000, three years ago.
Labor
Annual cost today/annual cost 10 years ago = index value today/ index value 10 years ago
 Annual cost now = $871800

Materials
Annual cost today/annual cost 3 years ago = index value today/ index value 3 years ago
 Annual cost now= $3227000
 ESTIMATION MODELS
POWER SIZING MODEL: Used to estimate the costs of industrial plants and equipment. The
model "scales up“ or "scales down“ known costs, thereby accounting for economies of scale.
Consider the cost to build a refinery. Would it cost twice as much to build the same facility
with double the capacity? It is unlikely. The power-sizing model uses the exponent (x), called
the power-sizing exponent, to reflect economies of scale in the size or capacity:
x
(
Cost at equipment A = Size (capacity of equipment A (
Cost at equipment B Size (Capacity) of B

Example: Mr Y wants to estimate the cost today of a 2500 ft 2 heat exchange

system for the new plant being analysed with the data; 5 years ago the price of
1000 ft2 exchanger was $50,000, power sizing exponent = 0.55 for this range
of heat exchangers, and five years ago the cost index for heat exchanger was
1306 which is 1487 now.

• Cost of 2500ft2 exchanger/Cost of 1000ft2 exchanger = (2500ft2/1000ft2)0.55

Cost of 2500ft2 heat exchanger = $82800
• Cost today/Cost 5 years ago = Index value today/Index value 5 years ago
Cost today = (1487/1306)x $82800 = $94300
 Estimating Benefits
For the most part, we can use exactly the same approach to
estimate benefits as to estimate costs:
– Fixed and variable benefits
– Recurring and non-recurring benefits
– Incremental benefits
– Life-cycle benefits
– Rough, semi-detailed, and detailed benefit estimates
– Difficulties in estimation
– Segmentation and index models

Major differences between benefit and cost estimation:

– Costs are more likely to be underestimated
– Benefits are most likely to be overestimated
– Benefits tend to occur further in the future than costs 43
 CASH FLOW DIAGRAMS
• Cash flow diagrams (CFD) Example:
summarize the costs and Time Period Size of Cash Flow
benefits of projects
0 (today) Receive $100 (positive CF)
1 Pay $100 (negative CF)
• A CFD illustrates the size, sign,
2 Positive CF of $100
and timing of individual cash
3 Negative CF of $150
flows
4 Negative CF of $150
• Periods may be months, 5 Positive CF of $50
quarters, years, etc.
COMMENTS: Tomorrow

• The end of one period is the

100 100
beginning of the next one
50

• Arrows point up for revenues or

benefits, down for costs 0 1 2 3 4 5
• One person’s payment (cash
outflow with -ve sign) is another 100
person’s receipt (cash inflow with Today
+ve sign) 150 150 44
 CASH FLOW DIAGRAM
Example: A machine will cost $30,000 to purchase. Annual operating and maintenance
costs (O&M) will be $2000. The machine will save $10,000 per year in labor costs. The
salvage value of the machine after 5 years will be $7000. Draw the cash flow diagram
 CASH FLOW DIAGRAM
Example: A machine will cost $30,000 to purchase. Annual operating and maintenance
costs (O&M) will be $2000. The machine will save $10,000 per year in labor costs. The
salvage value of the machine after 5 years will be $7000. Draw the cash flow diagram

$7000

$10000 $10000 $10000 $10000 $10000

1 2 3 4 5

$2000 $2000 $2000 $2000 $2000

$30,000
 CASH FLOW DIAGRAM
Example: Before evaluating the economic merits of a proposed investment, the XYZ
Corporation insists that its engineers develop a cash flow diagram of the proposal. An
investment of $10,000 can be made that will produce uniform annual revenue of $ 5310
for 5 years and then have a positive salvage value of $2000 at the end of year 5. Annual
expenses will be $ 3000 at the end of each year for operating and maintaining the
project. Draw a cash flow diagram for the 5 year life of project.
 CASH FLOW DIAGRAM
Example: Before evaluating the economic merits of a proposed investment, the XYZ
Corporation insists that its engineers develop a cash flow diagram of the proposal. An
investment of $10,000 can be made that will produce uniform annual revenue of $ 5310
for 5 years and then have a positive salvage value of $2000 at the end of year 5. Annual
expenses will be $ 3000 at the end of each year for operating and maintaining the
project. Draw a cash flow diagram for the 5 year life of project.

2000

5310 5310 5310 5310 5310

1 2 3 4 5

3000 3000 3000 3000 3000

10,000
 Two summer Camps have following data for a 12-week session:
Camp A Camp B
Charge per camper $120 per week Charge per camper $100 per week
Fixed costs $48,000 per session Fixed costs $60,600 per session
Variable cost per camper $80 per week Variable cost per camper $50 per week
Capacity 200 campers Capacity 150 campers
a. Develop the mathematical relationships for total cost and total
revenue for camp A

b. What is the total number of campers that will allow camp B to

breakeven?

c. What is the profit or loss for the 12-week session if camp A

operates at 80% capacity?

d. Determine the breakeven number of campers for the two camps49to

have equal total costs for a 12-week session.
ADDITIONAL
READING

50
Fixed Cost & Variable Cost
Industry
 Fixed cost industry
 revenue dollars contain more than 50 percent fixed costs
 airlines, computer software developers, & restaurants

 To pay this high percentage of fixed cost, they must sell a relatively
high volume

 Variable cost industry

 revenue dollars contain less than 50 percent fixed costs
 service businesses
 Insurance firms
 Computer software companies
 Material distributors
 Rental equipment companies

 In these companies the majority of their business cost is caused

by their sales volume.
51
Business Implications of Fixed Cost
Structure
 The nature of a specific business will have a lot to do
with defining its inherent fixed cost structure.
 Airlines have historically been burdened with high
fixed costs related to
 maintenance, contractual labor
agreements
 computer reservation systems
 aircraft
 Airlines struggled during lean years because they are
unable to cover fixed costs.
 During boom years these same companies are
extremely profitable because costs do not rise (much)
with increases in volume. Basically, there is not
much cost difference in flying a plane empty or full!
52
Avoid Fixed Costs
 Other businesses attempt to avoid fixed costs
so that they can maintain a more stable stream
of income relative to sales
 For example, a computer company might
outsource its tech support
 Rather than having a fixed staff that is either
idle or overloaded at any point in time, they
simply pay an independent support company a
per-call fee
 The effect is to transform the organization's
fixed costs to variable
53
Economies of Scale
 This means that certain efficiencies are
achieved as production levels rise.
 Fixed costs can be spread over larger
production runs and this causes a decrease in
the per unit fixed cost.
 In addition, enhanced buying power might
result (e.g., quantity discounts) as volume goes
up, and this can actually reduce the per unit
variable cost. These are valid considerations.

54
Committed Fixed Costs
 Committed Fixed Costs arise from an
organization's commitment to engage
in operations
 These elements include such items as
 depreciation, rent,
 insurance, property taxes
 These costs are not easily adjusted
with changes in business activity

55
 Discretionary Fixed Costs
 Discretionary Fixed Costs originate from top
management's yearly spending decisions
 Examples of discretionary fixed costs include
 advertising, employee training
 Proper planning can result in avoidance of these
costs if cutbacks become necessary or desirable

Committed fixed costs relate to desired long-run positioning

of firm,whereas discretionary fixed costs
have short-term orientation

56
MIXED COSTS
 Many costs contain both variable and fixed
components. These costs are called mixed
or semi variable.
 Cell phone agreements usually provide for a
monthly fee plus usage charges for excess
minutes, text messages, and so forth.
 With a mixed cost, there is usually some
fixed amount, plus a variable component
tied to an activity.

57
Example— Accept a Special
Offer
 A customer has offered you $ 15.00 for 5,000 units of your product.
You normally sell your product for $ 25.00. Should you accept this
offer?

 You currently produce and sell 40,000 units with a maximum

capacity of 50,000 units.
 Total manufacturing costs are $ 18.00 per unit, consisting of $
12.50 variable and $ 5.50 fixed.

 Change in Revenues $ 75,000 (5,000 x $

15.00)
 Change in Expenses ( 62,500) (5,000 x $
12.50)
 Net Change $ 12,500

 Conclusion: You should accept the special offer since it results in $

12,500 of additional income.
58
Contribution Margin

59
Contribution Margin
 Contribution margin :
 revenues minus variable expenses
 Contribution margin is a conceptual number
reflecting amount available from each sale, after
deducting all variable costs associated with the
units sold
 Some of these variable costs are product costs,
& some are selling & administrative in nature
 Contribution margin is generally a number
calculated for internal use and analysis
60
Contribution Margin: Aggregated/per
Unit/ratio

 Case in Point: Leyland Sports, a manufacturer of

score board signs.
 The production cost is $500 per sign, and Leyland
pays its sales representatives $300 per sign
sold. Thus, variable costs are $800 per sign.
 Each signs sells for $2,000.
 Leyland's contribution margin is $1,200 ($2,000 -
($500 + $300)) per sign.
 In addition, Assume that Leyland incurs
$1,200,000 of fixed costs, regardless of the level
of activity
61
 Contribution Margin
Assume 1,000 units are produced and sold

Total Per Unit Ratio

100%
Sales (1,000 X $2,000) $2,000,000 $2,000
800 40%
Variable costs (1,000 X $800) 800,000

$1,200,000 $1,200 60%

Contribution Margin
Fixed costs 1,200,000
Net income -0-

62
 What would happen if Leyland sold 2,000
units?

Total Per Unit Ratio

100%
Sales (2,000 X $2,000) $4,000,000 $2,000
800 40%
Variable costs (2,000 X $800) 1,600,000
$1,200 60%
Contribution Margin $2,400,000
Fixed costs 1,200,000
Net income $1,200,000

63
 What would happen if Leyland sold only 500
units?

Total Per Unit Ratio

$2,000 100%
Sales (500 X $2,000) $1,000,000.
Variable costs (500 X 800 40%
400,000.
$800)
$1,200 60%
Contribution Margin $ 600,000.
Fixed costs 1,200,000.
Net loss $(600,000)

 changes did not impact fixed costs, or change the

per unit or ratio calculations
 1,000 units achieved breakeven net income.
 At 2,000 units, Leyland managed to achieve a
$1,200,000 net income
 500 units resulted in a $600,000 loss.
64
A picture is worth a thousand
words

65
 Graphic Presentation

Dollars are represented on vertical axis and units on horizontal

66
Interpretation
 The total sales line starts at "0" and rises
$2,000 for each additional unit.
 The total cost line starts at $1,200,000
(reflecting the fixed cost), and rises $800 for
each additional unit (reflecting the addition of
variable cost).
 "Break-even" results where sales = total costs
 At any given point, the width of the loss area
(in red) or profit area (in green) is the
difference between sales and total costs.

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Outsourcing versus Insourcing

Outsourcing is Insourcing is
purchasing goods producing goods
and services from or providing services
outside vendors within the organization

68
or

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Currently, a firm manufactures the dashboards that it
uses in making automobiles. The cost of
manufacturing this part is summarized below. An
outside supplier has offered to provide the part for
$240. Should the car manufacturer accept the offer?

Direct materials $ 80
Direct labor 80
Variable factory overhead 52
Fixed factory overhead 68
Total cost per unit $280

INITIAL REACTION—DON’T MAKE

INTERNALLY 70
 Proposal to Manufacture Automobile Part
February 15, 2006
Purchase price of part $240.00
Cost to manufacture:
Direct materials $80.00
Direct labor 80.00
Variable factory overhead 52.00 212.00
Cost savings from manufacturing part $ 28.00

The
The fixed
fixed factory
factory overhead
overhead isis excluded
excluded
because
because itit isis not
not relevant—so
relevant—so continue
continue
making
making the the part.
part.
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