ENGINEERING

ECONOMICS

COST CONCEPTS AND

DESIGN ECONOMICS
COST CONCEPTS AND
DESIGN ECONOMICS

When Europe’s Airbus Company approved the A380 program in 2000, it

was estimated that only 250 of the giant, 555-seat aircraft needed to be
sold to break even. The program was initially based on expected
deliveries of 751 aircraft over its life cycle. Long delays and mounting
costs, however, have dramatically changed the original breakeven figure.
In 2005, this figure was updated to 270 aircraft. According to an article in
the Financial Times (October 20, 2006, p. 18), Airbus would have to sell
420 aircraft to break even—a 68% increase over the original estimate. To
date, only 262 firm orders for the aircraft have been received. The topic of
breakeven analysis is an integral part of this chapter.
COST TERMINOLOGY
There are a variety of costs to be considered in an
engineering economic analysis. These costs differ in
their frequency of occurrence, relative
magnitude, and degree of impact on the study.

• Fixed Costs
• Variable Costs
• Incremental Costs
COST TERMINOLOGY
Fixed Cost
Fixed costs are those 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.
COST TERMINOLOGY
Variable Cost
Variable costs are those associated with an operation that
varies in total with the quantity of output or other
measures of activity level.
For example, the costs of
material and labor used in a
product or service are variable
costs, because they vary in total
with the number of output units,
even though the costs per unit
stay the same. Variable costs
are also known as avoidable
costs.
COST TERMINOLOGY
Incremental Cost
An incremental cost (or incremental revenue) is the
additional cost (or revenue) that results from increasing
the output of a system by one (or more) units.

For instance, the incremental cost per mile for driving an

automobile may be $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.

Also, it is common to read about the “incremental cost of producing

a barrel of oil” and “incremental cost to the state for educating a
student.”

As these examples indicate, the incremental cost (or revenue) is

often quite difficult to determine in practice.
COST TERMINOLOGY
Fixed vs Variable Cost
COST TERMINOLOGY
Fixed and Variable Cost
COST TERMINOLOGY
Fixed and Variable Cost
COST TERMINOLOGY
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.
COST TERMINOLOGY
Direct, Indirect, and Standard Costs
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
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.
COST TERMINOLOGY
Direct, Indirect, and Standard Costs
COST TERMINOLOGY
Direct, Indirect, and Standard Costs
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).

Some typical uses are the following:

1.Estimating future manufacturing costs
2.Measuring operating performance by comparing actual
cost per unit with the
3.standard unit cost
4.Preparing bids on products or services requested by
customers
5.Establishing the value of work in process and finished
Cost-Driven Design Optimization
Cost-Driven Design Optimization
Cost-Driven Design Optimization
COST TERMINOLOGY
Cash and Book Costs
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.
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 an analysis only because it
affects income taxes, which are cash
flows.
COST TERMINOLOGY
Sunk Costs
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.
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.
COST TERMINOLOGY
Opportunity Costs
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.
COST TERMINOLOGY
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
identification of the
economic need or want
(the requirement) and ends
with retirement and
disposal activities.
The life cycle may be
divided into two general
time periods: the
acquisition phase and
the operation phase.
The General Economic
Environment
In broad terms, economics deals with the interactions between people
and wealth, and engineering is concerned with the cost-effective use of
scientific knowledge to benefit humankind.

This section introduces some of these basic economic concepts and

indicates how they may be factors for consideration in engineering
studies and managerial decisions.
Consumer and Producer Goods
and Services
Consumer goods and
services are those Producer goods and services
products or services that are used to produce
are directly used by people consumer goods and
to satisfy their wants. Food, services or other producer
clothing, homes, cars, goods. Machine tools,
television sets, haircuts, factory buildings, buses, and
opera, and medical farm machinery are
services are examples. examples.
Measures of Economic Worth

Goods and services are produced and desired because they

have utility—the power to satisfy human wants and needs.

Much of our business activity, including engineering, focuses

on increasing the utility (value) of materials and products by
changing their form or location.
Necessities, Luxuries, and Price
Demand
Goods and services may be divided into two types: necessities
and luxuries.

Obviously, these terms are relative, because, for most goods and services, what
one person considers a necessity may be considered a luxury by another. For
example, a person living in one community may find that an automobile is a
necessity to get to and from work. If the same person lived and worked in a
different city, adequate public transportation might be available, and an automobile
would be a luxury.
Competition

Because economic laws are general statements regarding the

interaction of people and wealth, they are affected by the
economic environment in which people and wealth exist.

Most general economic

principles are stated for
situations in which perfect
competition exists.
Competition

Perfect competition occurs in a situation Monopoly is at the opposite pole from

in which any given product is supplied perfect competition. A perfect
by a large number of vendors and there monopoly exists when a unique
is no restriction on additional suppliers product or service is only available
entering the market. Under such from a single supplier and that vendor
conditions, there is assurance of can prevent the entry of all others into
complete freedom on the part of both the market. Under such conditions, the
buyer and seller. buyer is at the complete mercy of the
supplier in terms of the availability and
price of the product.
Price-Demand Relation

For all goods and services, there is a relationship between the price
that must be paid and the quantity that will be demanded or
purchased. This general relationship is depicted in Figure 2-2.
As the selling price per unit (p) is
increased, there will be less demand (D)
for the product, and as the selling price
is decreased, the demand will increase.

The relationship between price and

demand can be expressed as the linear
function;

p = a − bD
for 0 ≤ D ≤ a , and a > 0, b > 0,

where a is the intercept on the price axis

and −b is the slope. Thus, b is the
amount by which demand increases for
each unit decrease in p.
The 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.
TR = price × demand = p·D

If the relationship between price and demand as given in Equation (2-1) is used

TR = (a−bD)D = aD−bD2
For 0≤D≤ a and a>0, b>0
The Total Revenue Function

The relationship between total

revenue and demand for the
condition expressed in Equation
(2-4) may be represented by the
curve shown in Figure 2-3. From
calculus, the demand, Dˆ , that will
produce maximum total revenue
can be obtained by solving

dTR/dD =a−2bD=0
D=a/2b
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 (Section 2.1.1).

CT =CF +CV
where CF and CV denote fixed and variable costs,
respectively. For the linear relationship assumed here,

CV =cv·D
where cv is the variable cost per unit.
In this section, we consider two scenarios for finding breakeven points. In
the first scenario, demand is a function of price. The second scenario
assumes that price and demand are independent of each other.
Cost, Volume, and Breakeven Point
Relationships
CASE 1: Price is a function of
demand

At breakeven point D1,

total revenue is equal to
total cost, and an increase
in demand will result in a
profit for the operation.

Profit (loss) = total revenue − total costs = (aD−bD2)−(CF

+cvD)
=−bD2 +(a−cv)D−CF
 Cost, Volume, and Breakeven Point
Relationships
Profit (loss) = total revenue − total
costs
= (aD−bD2)−(CF +cvD)
=−bD2 +(a−cv)D−CF
In order for a profit to occur, based on
Equation (2-9), and to achieve the typical
results depicted in Figure, two conditions
must be met:

1. (a−cv)>0; that is, 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 (TR) must exceed total
cost (CT) for the period involved.
 Cost, Volume, and Breakeven Point
Relationships
If these conditions are met, we can find the
optimal demand at which maximum profit
will occur by taking the first derivative of
Equation (2-9) with respect to D and setting
it equal to zero:

To ensure that we have maximized profit

(rather than minimized it), the sign of the
second derivative must be negative.
Checking this, we find that
Cost, Volume, and Breakeven Point
Relationships
Cost, Volume, and Breakeven Point
Relationships
Cost, Volume, and Breakeven Point
Relationships
Cost, Volume, and Breakeven Point
Relationships
Cost, Volume, and Breakeven Point
Relationships
CASE 2: Price is a NOT function of demand (is
constant)

When the price per unit (p) for a

product or service can be
represented more simply as being
independent of demand [versus
being a linear function of demand,
as assumed in Equation (2-1)]
and is greater than the variable
cost per unit (cv), a single
breakeven point results. Then,
under the assumption that
demand is immediately met, total
revenue (TR) = p · D.
Cost, Volume, and Breakeven Point
Relationships
CASE 2: Price is a NOT function of demand (is
constant)
Cost, Volume, and Breakeven Point
Relationships
CASE 2: Price is a NOT function of demand (is
constant)
Cost, Volume, and Breakeven Point
Relationships

Market competition often creates

pressure to lower the breakeven
point of an operation; the lower
the breakeven point, the less
likely that a loss will occur during
market fluctuations. Also, if the
selling price remains constant
(or increases), a larger profit will
be achieved at any level of
operation above the reduced
breakeven point.
Present Economy Studies
When alternatives for accomplishing a specific task are
being compared over one year or less and the influence of
time on money can be ignored, engineering economic
analyses are referred to as present economy studies.
Present Economy Studies
Present Economy Studies
Present Economy Studies
Present Economy Studies
Present Economy Studies
Present Economy Studies
Cost-Driven Design
Optimization
Examples of cost minimization through effective design
are plentiful in the practice of engineering.
We will consider discrete and continuous optimization
problems that involve a single design variable, X. This
variable is also called a primary cost driver, and
knowledge of its behavior may allow a designer to
account for a large portion of total cost behavior.
Cost-Driven Design Optimization
For cost-driven design optimization problems, the two
main tasks are as follows:

1.Determine the optimal value for a certain alternative’s

design variable. For example, what velocity of an aircraft
minimizes the total annual costs of owning and operating
the aircraft?

2.Select the best alternative, each with its own unique

value for the design variable. For example, what
insulation thickness is best for a home in Virginia: R11,
R19, R30, or R38?
Cost-Driven Design Optimization
Cost-Driven Design Optimization
Cost-Driven Design Optimization