ENGINEERING ECONOMY

(BPK 30902/BNP 30402)

CHAPTER 2:
FUNDAMENTAL COST
CONCEPTS

TS. DR. ROSLINDA BINTI ALI

FAKULTI TEKNOLOGI KEJURUTERAAN
CONTENTS:
Introduction
Cost Terminology
Fixed Costs, Variable Costs and Total Costs
Recurring and Non-recurring Cost
Direct, Indirect and Standard Cost
Cash Cost versus Book Cost
Sunk Cost
Opportunity Cost
Life-cycle Cost
COST TERMINOLOGY
There are a variety of costs to be considered in an EE
analysis.

These costs differ in their frequency of occurrence, relative

magnitude and degree of impact by defining a number of cost
categories and illustrate how they should be treated in an EE
analysis.
FIXED COSTS
Unaffected by changes in activity level over a feasible range
of operations.

Also known as ‘indirect costs’

E.g.
•Insurance and taxes on facilities
•General management and administrative salaries
•License fees
•Interest cost on borrowed capital
VARIABLE COSTS
Associated with an operation that varies in total with the
quantity of output or other measures of activity level.

Also known as ‘direct costs’

E.g.
•The costs of material and labour used in a product or service

Direct labour
Subcontractors
Marketing
Advertisement
INCREMENTAL COSTS
Additional cost (or revenue) that results from increasing the
output of a system by one (or more) units.

E.g.
•Incremental cost per mile for driving
•Incremental cost of producing a barrel of oil
•Incremental cost to the state for educating a student
TOTAL COSTS
Total Cost (TC) is the sum of Fixed Cost (FC) and
Variable Cost (VC).

TC = FC + VC

whereby: FC do not change as the

production (Q) increases
: VC increase as the production (Q)
increases
TOTAL COSTS
(CONT.)
In general, the equation for Cost (C) is as follows:

C = F + aQ

whereby F : Fixed Cost

aQ: Variable Cost
a : Average Variable Cost
TOTAL REVENUE
In general, equation for revenue is as follows:

R = TR - TC

whereby: R = revenue
TR = total revenue
TC = total cost
BREAK EVEN POINT

TR = TC

whereby TR = total revenue

TC = total cost
EXERCISE 1
Classify each of the following cost items as mostly fixed or variable:

Fixed cost Variable costs

Raw materials √

Direct labour √
Insurance (building and √
equipment)
Supplies √
Utilities
√ √
Property taxes
√
Interest on borrowed money
√
Administrative salaries
Payroll taxes √

Sales commission √ √
Rent √
Depreciation √

√
EXERCISE 2
The cost for producing 10 pieces of shirts is RM350, while
the cost for producing 20 pieces of shirts is RM600. Derive
the equation for the shirts’ cost production.

Answer:
C = F + aQ
C = 100 + 25Q
EXERCISE 3
Sharp Manufacturing (SMM) manufactures flat screen TV for
global market. This industry requires total manufacturing
cost of RM500,000 to produce 100 units TV per month. The
production can be increased to 150 units per month with total
manufacturing cost of RM600,000.

• Formulate linear equations for this case.

• Determine the fixed cost (FC) and variable cost (VC)

EXERCISE 3 (SOLUTION)
TC1 = RM500,000, Q1 = 100 units/month.
TC2 = RM600,000, Q2 = 150 units/month
•Formulate linear equations for this case.
500,000 = FC + 100V ----------- (1)
600,000 = FC + 150V ----------- (2)
•Determine the fixed cost (FC) and variable cost (V)
•From (1); FC = 500000 – 100V
•Substitute (1) into (2); 600000 = 500000 -100V + 150V
V = 100000/50 = RM 2000
•From (1); FC = 500000 – 100(2000)
FC = RM 300,000
 EXERCISE 4
A variable cost of RM5 is needed to process 1kg of coffee. The
fixed cost is RM300/day. Assumption: price of the coffee: RM10/kg.

a)Derive an equation for total cost of coffee production

b)Calculate the total cost for 1000kg coffee produced in a day
c)Calculate the break even point
d)Calculate the profit for 100kg coffee production in a day
e)Calculate the profit for 50kg coffee production in a day
A) DERIVE AN EQUATION FOR TOTAL COST OF COFFEE
PRODUCTION:

C = F + aQ
C = 300 + 5Q
B) CALCULATE THE TOTAL COST FOR 1000KG COFFEE
PRODUCED IN A DAY:

C = 300 + 5Q
= 300 + 5(1,000)
= RM 5,300
C) CALCULATE THE BREAK EVEN POINT:

TR = TC
10Q = 300 + 5Q
5Q = 300
Q = 60 kg/day
D) CALCULATE THE PROFIT FOR 100KG COFFEE
PRODUCTION IN A DAY:

R = TR – TC
= 10 (100) – [300 + 5(100)]
= 1000 – 300 – 500
= RM200
E) CALCULATE THE PROFIT FOR 50KG COFFEE
PRODUCTION ON A DAY:

R = TR – TC
= 10 (50) – [300 + 5(50)]
= 500 – 300 – 250
= -RM50
EXERCISE 5
A contractor has a choice of two sites on which to set up the
asphalt-mixing plant equipment. Factors relating to the two mixing sites
are as follows (production costs at each site are the same):
Cost factor Site A Site B

Average hauling distance 6 miles 4.3 miles

Monthly rental of site RM1,000.00 RM5,000.00

Cost to set up and remove equipment RM15,000.00 RM25,000.00

Hauling expenses (per cubic yard mile) RM1.15/yd3-mile RM1.15/yd3-mile

Flag person Not required RM96/day

The job requires 50,000 cubic yards of mixed-asphalt-paving materials.

It is estimated that four months (17 weeks of five working days per
week) will be required for the job.
A) COMPARE THE TWO SITES IN TERMS OF THEIR
FIXED, VARIABLE AND TOTAL COSTS. WHICH IS THE
BETTER SITE?

Cost Fixed Variable Site A Site B

Rent √ RM4,000.00 RM20,000.00

Setup/removal √ RM15,000.00 RM25,000.00

Flag person √ - RM8,160.00

Hauling √ RM345,000.00 RM247,250.00

Total RM364,000.00 RM300,410.00

Site B is better for it has smaller total costs for the job.
B) FOR THE SELECTED SITE, HOW MANY CUBIC YARDS OF
PAVING MATERIAL DOES THE CONTRACTOR HAVE TO DELIVER
BEFORE STARTING TO MAKE A PROFIT IF PAID RM8.05 PER
CUBIC YARD DELIVERED TO THE JOB LOCATION?

Variable cost: 4.3(RM1.15) = RM4.95

Total cost = Total revenue

RM53,160.00 + RM4.95x = RM8.05x
x =17,148 cubic yards delivered
DIRECT COST
Cost that are reasonable measured and
allocated to a specific work activity

E.g. Labour & material costs directly associated

with product, service or construction activity
The materials needed to make a pair of scissors
would be a direct cost
INDIRECT COST
Costs that are difficult to attribute or allocate to a specific
output or work activity.

Normally, they are costs allocated through a selected

formula. E.g.: cost of common tools, general supplies and
equipment maintenance in a plant.

Overhead consists of plant operating costs that are not

direct labour or direct material costs. E.g.: electricity
general repairs, property taxes

The terms indirect cost and overhead are used

interchangeably.
STANDARD COST
Planned cost per unit of output that are established in advance
of actual production or service delivery.

Developed from anticipated direct labour hours, materials, and

overhead categories (with their established costs per unit)

Play an important role in cost control and other management

function.
 STANDARD COST
(CONT.)
Examples:

1. Estimating future manufacturing goals;

2. Measuring operating performance by comparing actual cost per
unit with the standard unit cost; and
3. Preparing bids on products or services requested by customers.
CASH COST VERSUS BOOK COST
CASH COST BOOK COST (NON-CASH COST)
Involves payment of cash Does not involve a cash transaction
and is reflected in the accounting
system
Results in a cash flow Do not involve cash payments but
rather represent the recovery of
past expenditures over a fixed a
period of time. E.g. depreciation

In EE analysis, only those costs that are cash flows or potential cash
flows from the defined perspective for the analysis need to be
considered.
SUNK COST (KOS HANGUS)
Occurred in the past and has no relevance to estimates of
future costs and revenues related to an alternative course
of action.

Is common to all alternatives, is not part of the future

(prospective) cash flow and can be disregarded in an EE
analysis.
SUNK COST (CONT.)
Example:
▪ A firm is considering the replacement of a piece of
equipment. It originally cost RM50,000, is presently
shown on the company records with a value of RM20,000,
and can be sold for an estimated RM5,000.
▪ Therefore, the sunk cost is: (RM20,000 – RM5,000) =
RM15,000.
OPPORTUNITY COST (KOS
LEPAS BARANG)
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 (i.e. foregone)

opportunity and is often hidden or implied.
OPPORTUNITY COST (CONT.)
Example:
▪ A firm is considering the replacement of a piece of
equipment. It originally cost RM50,000, is presently
shown on the company records with a value of RM20,000,
and can be sold for an estimated RM5,000.
▪ The present investment in the equipment should be
considered as RM5,000, because, by keeping the
equipment, the firm is giving up the opportunity to obtain
RM5,000 from its disposal.
RECURRING COSTS
Periodic

Annual expenses items for direct & indirect cost

associated with five primary resources

E.g. people, machines, materials, energy &

information - major part expenses
NON-RECURRING COSTS
One time cost

Expenses for shutting down operation & retirement

& disposal of assets

E.g. Personal, materials, transportation etc.

LIFE-CYCLE COST
Refers to a summation of all the costs related to a product,
structure, system or service during its life span.

The life cycle begins with identification of the economic

need or want (the requirement) and ends with retirement
and disposal activities.

It is a time horizon that must be defined in the context of

the specific situation and the end of the life cycle may be
projected on a functional or an economic basis.

Is divided into two general time periods: acquisition and

operational phase
 LIFE-CYCLE COST
(CONT.)

High Potential for

life-cycle cost
saving

Cumulative
life-cycle
cost

Cost Cumulative
(RM) commited
life-cycle
cost

Time
0
Needs Conceptual Details Production or
Operation or Retirement &
assessment: (preliminary) design construction
customer use: disposal
defination of design: production or
maintenance
requirement advanced construction
& support
development planning:
prototype facility &
testing resources
accquisition

Acquisition phase Operation phase

LIFE-CYCLE COST
(CONT.)
LIFE-CYCLE COST –
THE ACQUISITION PHASE
1) Analysis on the economic need or want
- To make explicit the requirement for the product, structure, system,
or service.
- With the requirement explicitly defined, the other activities in the
acquisition phase can proceed in a logical sequence
2) Conceptual design activities
- Translate the defined technical and operational requirements into
a preferred preliminary design.
- Activities: development of the feasible alternatives; advanced
development; prototype testing.
3) Detailed design and planning for production/construction
- Activities necessary to prepare, acquire, and make ready for
operation the facilities and other resources needed.

EE studies are an essential part of design process to analyze & compare

alternatives & to assist in determing the final details design
LIFE-CYCLE COST –
THE OPERATION PHASE
The production, delivery, or construction of the end
item(s) or service and their operation or customer use
would occur

Ends with retirement from active operation or use and,

often, disposal of the physical assets involved.

The priorities if EE in this phase:

▪ Achieving efficient and effective support to operations
▪ Determining whether (and when) replacement of assets
should occur
▪ Projecting the timing of retirement and disposal activities
LIFE-CYCLE COST –
CATEGORIES
Investment cost
▪ Capital required for most activities in the acquisition
phase
▪ E.g. Single expenditure & series of expenditure
▪ a.k.a. capital investment

Working capital
▪ Funds required for the start-up & support of operational
activities
▪ E.g. Material for product/ spare part for maintenance/ cash
for salaries etc
LIFE-CYCLE COST –
CATEGORIES (CONT.)
Operation and maintenance cost (O&M)
▪ Includes many of the recurring annual expenses items
associated with operation phase of LC
▪ Direct & indirect cost of operation associated with 5
primary resources (people/machines, materials/ energy/
information

Disposal cost
▪ Includes those non-recurring costs of shutting down the
operation & the retirement & disposal of assets at of LC
THANK YOU…