Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines
COLLEGE OF ENGINEERING
BES 4 – ENGINEERING ECONOMICS Period: 1st Sem. AY .2023-2024
Subject Instructor: Engr. Frances Angelique U. Cereno Course and Year: BSCE 3
Learning Material No. and Title: 2. Introduction (2 of 2) Time Allotment: Week 2
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Introduction (2 of 2)
Outline of Topics
1. Cost Concepts for Decision Making
2. Present Economy Studies
Specific Intended Learning Outcome/s (SILOs)
At the end of this topic, the student should be able to:
• Identify the effect of cost for decision-making and;
• Solve problems involving present economic studies
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Lesson 4: Cost Concepts for Decision Making
A variety of costs that differs in frequency of occurrence, relative magnitude, and degree of impact on the
study must be considered in an engineering economic analysis. In this learning material, we will define these costs
and show how they are treated in an engineering economic analysis.
Fixed, Variable, and Incremental Costs
Those costs that are not affected by the changes in activity level are called fixed costs. They remain constant
over a specific range of operating conditions. Examples of fixed costs are insurances, taxes on facilities,
administrative salaries, license fees, and interest costs on borrowed capital.
Another type of cost, called variable costs, are those costs that vary directly with the quantity of the output or
any other measure of activity level. For example, the cost of material and labor used in the production of a certain
good. It is considered a variable cost because it will vary depending on the total number of the produced goods, even
though the cost per unit of the good stays the same.
Incremental costs are the additional costs due to increasing the output of a system by one or more units. For
instance, the incremental cost per mile for driving an automobile maybe $0.49, but this cost depends on
considerations such as total mileage driven during the year (normal operating range), mileage expected for the next
major trip, and the age of the automobile.
Direct, Indirect, and Standard Costs
Direct costs are costs that can be reasonably measured and allocated to a specific output or work activity. The
labor and material costs directly associated with a product, service, or construction activity are direct costs. For
example, the materials needed to make a pair of scissors would be a direct cost.
Indirect costs are costs that are difficult to allocate to a specific output or work activity. Normally, they are
costs allocated through a selected formula (such as proportional to direct labor hours, direct labor dollars, or direct
BES 4 – Engineering Economics Page 1 of 7
Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines
COLLEGE OF ENGINEERING
material dollars) to the outputs or work activities. For example, the costs of common tools, general supplies, and
equipment maintenance in a plant are treated as indirect costs.
Overhead consists of plant operating costs that are not direct labor or direct material costs. In this book, the
terms indirect costs, overhead, and burden are used interchangeably. Examples of overhead include electricity,
general repairs, property taxes, and supervision. Administrative and selling expenses are usually added to direct costs
and overhead costs to arrive at a unit selling price for a product or service.
Standard costs are planned costs per unit of output that are established in advance of actual production or
service delivery. They are developed from anticipated direct labor hours, materials, and overhead categories (with
their established costs per unit). Because total overhead costs are associated with a certain level of production, this is
an important condition that should be remembered when dealing with standard cost data. Standard costs play an
important role in cost control and other management functions. Some typical uses are the following:
1. Estimating future manufacturing costs
2. Measuring operating performance by comparing actual cost per unit with the standard unit cost
3. Preparing bids on products or services requested by customers
4. Establishing the value of work in process and finished inventories
Cash Cost vs. Book Cost
A cost that involves payment of cash is called a cash cost (and results in a cash flow) to distinguish it from
one that does not involve a cash transaction and is reflected in the accounting system as a noncash cost. This
noncash cost is often referred to as a book cost. Cash costs are estimated from the perspective established for the
analysis and are the future expenses incurred for the alternatives being analyzed. Book costs are costs that do not
involve cash payments but rather represent the recovery of past expenditures over a fixed period of time. The most
common example of book cost is the depreciation charged for the use of assets such as plant and equipment. In
engineering economic analysis, only those costs that are cash flows or potential cash flows from the defined
perspective for the analysis need to be considered. Depreciation, for example, is not a cash flow and is important in
the analysis only because it affects income taxes, which are cash flows.
Sunk Cost
A sunk cost is one that has occurred in the past and has no relevance to estimates of future costs and
revenues related to an alternative course of action. Thus, a sunk cost is common to all alternatives, is not part of the
future (prospective) cash flows, and can be disregarded in an engineering economic analysis. For instance, sunk
costs are nonrefundable cash outlays, such as earnest money on a house or money spent on a passport.
Suppose that Joe College finds a motorcycle he likes and pays $40 as a down payment, which will be applied
to the $1,300 purchase price, but which must be forfeited if he decides not to take the cycle. Over the weekend, Joe
finds another motorcycle he considers equally desirable for a purchase price of $1,230. For the purpose of deciding
which cycle to purchase, the $40 is a sunk cost and thus would not enter into the decision, except that it lowers the
remaining cost of the first cycle. The decision then is between paying an additional $1,260 ($1,300 − $40) for the first
motorcycle versus $1,230 for the second motorcycle.
In summary, sunk costs are irretrievable consequences of past decisions and therefore are irrelevant in the
analysis and comparison of alternatives that affect the future. Even though it is sometimes emotionally difficult to do,
sunk costs should be ignored, except possibly to the extent that their existence assists you to anticipate better what
will happen in the future.
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Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines
COLLEGE OF ENGINEERING
Opportunity Cost
An opportunity cost 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.
Consider a student who could earn $20,000 for working during a year but chooses instead to go to school for
a year and spend $5,000 to do so. The opportunity cost of going to school for that year is $25,000: $5,000 cash outlay
and $20,000 for income foregone. (This figure neglects the influence of income taxes and assumes that the student
has no earning capability while in school.)
Life-Cycle Cost
This term 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 the identification of
the economic need or wants (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—whether it is a highway
bridge, a jet engine for commercial
aircraft, or an automated flexible
manufacturing cell for a factory. The
end of the life cycle may be
projected on a functional or an
economic basis. For example, the
amount of time that a structure or
piece of equipment is able to
perform economically may be
shorter than that permitted by its
physical capability. Changes in the
design efficiency of a boiler illustrate this situation. The old boiler may be able to produce the steam required, but not
economically enough for the intended use.
The life cycle may be divided into two general time periods: the acquisition phase and the operation phase.
Each of these phases is further subdivided into interrelated but different activity periods.
The acquisition phase begins with an analysis of the economic need or want — the analysis necessary to
make explicit the requirement for the product, structure, system, or service. Then, with the requirement explicitly
defined, the other activities in the acquisition phase can proceed in a logical sequence. The conceptual design
activities translate the defined technical and operational requirements into a preferred preliminary design. Included in
these activities are development of the feasible alternatives and engineering economic analyses to assist in the
selection of the preferred preliminary design. Also, advanced development and prototype-testing activities to support
the preliminary design work occur during this period.
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Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines
COLLEGE OF ENGINEERING
The next group of activities in the acquisition phase involves detailed design and planning for production or
construction. This step is followed by the activities necessary to prepare, acquire, and make ready for operation the
facilities and other resources needed. Again, engineering economy studies are an essential part of the design process
to analyze and compare alternatives and to assist in determining the final detailed design.
In the operation phase, the production, delivery, or construction of the end item(s) or service and their
operation or customer use occur. This phase ends with retirement from active operation or use and, often, disposal of
the physical assets involved. The priorities for engineering economy studies during the operation phase are (1)
achieving efficient and effective support to operations, (2) determining whether (and when) replacement of assets
should occur, and (3) projecting the timing of retirement and disposal activities. The figure on the previous page
shows relative cost profiles for the life cycle. The greatest potential for achieving life-cycle cost savings is early in the
acquisition phase. How much of the life-cycle costs for a product (for example) can be saved is dependent on many
factors. However, effective engineering design and economic analysis during this phase are critical in maximizing
potential savings.
Thus, one purpose of the life-cycle concept is to make explicit the interrelated effects of costs over the total
life span for a product. An objective of the design process is to minimize the life-cycle cost—while meeting other
performance requirements—by making the right trade-offs between prospective costs during the acquisition phase
and those during the operation phase. The cost elements of the life cycle that need to be considered will vary with the
situation. Because of their common use, however, several basic life-cycle cost categories will now be defined.
The investment cost is the capital required for most of the activities in the acquisition phase. In simple cases, such as
acquiring specific equipment, an investment cost may be incurred as a single expenditure. On a large, complex
construction project, however, a series of expenditures over an extended period could be incurred. This cost is also
called a capital investment.
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 a 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. Normally, costs associated with personnel, materials, transportation, and
one-time special activities can be expected. These costs will be offset in some instances by receipts from the sale of
assets with remaining market value. A classic example of a disposal cost is that associated with cleaning up a site
where a chemical processing plant had been located.
Lesson 5: Present Economy Studies
Present economy encompasses the analysis of problems encountered in the manufacture of goods or
rendering of services based on present or immediate costs. This usually occurs in instances where the effects of
depreciation and interest are negligible and is employed when the alternatives will yield similar results and the time
span of the study is short.
The following are the seven situations where present economy studies are applied.
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Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines
COLLEGE OF ENGINEERING
Selection of Materials
This is conducted when two or more materials necessary for the production of a certain good are available
and both will give satisfactory results. Present economy study in the selection of materials aids in the selection
process by considering the cost of production of each material and their processing.
Example Problem 5.1:
A machine part to be machined may be made either from an alloy of aluminum or steel. There is an order for
8,000 units. Steel costs ₱3.80 per kg, while aluminum costs ₱8.70 per kg. If steel is used, the steel per unit weighs
110 grams; for aluminum, 30 grams. When steel is used, 50 units can be produced per hour; for aluminum, 80 units
per hour with the aid of a tool costing ₱640, which will be useless after the 8,000 units are finished. The cost of the
machine and operator is ₱10.80 per hour. If all other costs are identical, determine which material will be more
economical.
Selection of Method
In cases where two or more possible methods are available and will yield equally satisfactory results, the
present economy study is used to determine the most economical one. This is common when deciding between
manual labor or the use of machinery in construction or production. Another example is the delivery of goods by
various methods.
Example Problem 5.2:
The ore on a gold mine in the Mountain Province contains, on the average, 0.5 gram of gold per ton. One
method of processing costs ₱1,650 per ton and recovers 93% of the gold, while another method costs only ₱1,500
per ton and recovers 81% of the gold. If gold can be sold at ₱8,500 per gram, which method is better and by how
much?
Selection of Design
This is applicable in cases where multiple designs for a machine used to produce a certain product are
prepared by the engineer. In this selection, the design that will do the work with utmost economy will be chosen.
Example Problem 5.3:
A company manufactures 1,000,000 units of a product yearly. A new design of the product that will reduce
materials cost by 12%, but will increase processing cost by 2%. If materials cost is ₱1.20 per unit and processing will
cost ₱0.40 per unit, how much can the company afford to pay the for the preparation of the new design and making
changes in the equipment?
Site Selection
In this process, several factors such as the price of the land, construction cost, availability of labor force, and
many other factors are considered. In civil projects involving earthworks, the distance of the borrow pit greatly affects
the cost of the earth to be transported.
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Republic of the Philippines
CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines
COLLEGE OF ENGINEERING
Example Problem 5.4:
A certain masonry dam requires 200,000 cu.m. of gravel for its construction. The contractor found two
possible sources for the gravel with the following data:
Source A Source B
Average distance of gravel pit to dam site 3 km 1.2 km
Gravel cost per cu.m. at pit - ₱10.00
Purchase price of pit ₱800,000 -
Road construction necessary ₱450,000 None
Overburden to be removed at ₱4.20 per cu.m. - 90,000 cu.m.
Hauling cost per cu.m. per km. ₱4.00 ₱4.00
Which of the two sites will give lesser cost?
Comparison of Proficiency Workers
Not all workers have the same efficiency. Their efficiency and proficiency in the work can be translated into
monetary values.
Example Problem 5.5:
Two workers, A and B, each produce 200 pieces of a product per hour. Because of defects, 2% of the pieces
produced by B is rejected. These defective pieces are repaired at a unit cost of ₱0.60 per piece. The cost of materials
per piece is at ₱2.50.
Economy of Tool and Equipment Maintenance
From time to time, the tools and equipment must be maintained in order to operate in optimum level. Mostly, it
is the experience that will indicate the best time to perform maintenance on the equipment to achieve the highest level
of efficiency.
Example Problem 5.6:
A machine used to cut materials in a factory has the following outputs per hour at various speeds and requires
periodic tool regarding at the intervals cited.
Speed Output per Hour Tool Regrinding
A 200 pcs. Every 8 hours
B 250 pcs. Every 7 hours
C 280 pcs. Every 5 hours
A set of tools costs ₱1,800.00 and can be ground twenty times. Each regrinding costs ₱18.00 and the time
needed to regrind and change tools is 1 hour. The machine operator is paid ₱28.00 per hour, including the time the
tool is changed. The tool grinder who also sets the tools to the machine is paid at ₱25.00 per hour. The hourly rate
chargeable against the machine is ₱54.00, regardless of the machine speed. Which speed is most economical?
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CAMARINES NORTE STATE COLLEGE
F. Pimentel Avenue, Brgy. 2, Daet, Camarines Norte – 4600, Philippines
COLLEGE OF ENGINEERING
Economy in the Utilization of Personnel
There is a certain number of workers that will provide the highest productivity and when this number is
exceeded, a number of workers might be idle in certain period. This study will minimize the idleness of the workers by
determining the most economic number crew members.
Example Problem:
A man decided to paint his house himself after office hours. He can paint 25 sq.m. per hour on the average. It
takes him 15 minutes to prepare materials and 20 minutes to keep the materials after painting. If there are 900 sq.m.
to be painted, how long will it take him to paint his house if he devotes 2.5 hours per day?
References:
Engineering Economy, Sixteenth Edition by William Sullivan, Elin Wicks, and Patrick Koelling; © 2015
Engineering Economy, Third Edition by Matthias Arreola; © 1993
BES 4 – Engineering Economics Page 7 of 7
