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University of Nebraska

Chapter 2: ���Engineering Costs and

Cost Estimating BSEN 206. Engineering Economy

Jeffrey C. Woldstad, Ph.D., P.E.

Fixed and Variable Costs -  Fixed Costs: constant, independent of the output or

activity level.

-  Property taxes, insurance

-  Management and administrative salaries

-  License fees, and interest costs on borrowed capital

-  Rental or lease

-  Variable Costs: Proportional to the output or activity level.

-  Direct labor cost

-  Direct materials

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Problems 1-6 For each of the following, are they: (A) fixed costs or (B) variable costs?���

1. Your rent each month?

2. Your electricity bill?

3. Your cable TV bill?

4. A companies hourly labor cost?

5. A companies engineering labor cost?

6. A companies Taxes?

Fixed and Variable Costs -  Total Variable Cost (TVC) = Unit Variable Cost

(VC) * Quantity (Q)

TVC = VC * Q

-  Total Cost (TC) = Fixed Cost (FC) + Total Variable Cost (TVC)

TC = FC + VC * Q

-  Total Revenue (TR) = Unit Selling Price (SP) * Quantity (Q)

TR = SP * Q 4

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Problem 6 To help pay for college, you have decided to start selling coffee outside of Othmer Hall. Costs associate with this are: $10,000 for the coffee stand and $0.50 per cup of coffee in supplies (coffee, cups and electricity)?

What is the minimum you should consider selling a cup of coffee for?

(A) $0.50

(B) $0.51

(C) $1.00

(D) $2.00

Problem 7 Based on the market value for coffee, you set your price at $1.00 per cup. How many cups of coffee do you need to sell to start making a profit?

(A) 1

(B) 10,000

(C) 20,000

(D) 50,000

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Breakeven Point -  Because most operations have both fixed and variable costs,

the selling price is set to a level above the variable costs – what happens if this is not the case?

-  Break-even point (BEP): the output level at which total revenue is equal to total cost.

SP * BEP = FC + VC * BEP

BEP = FC / (SP - VC)

-  Applications of Break-even Analysis:

-  Determining minimum production quantity

-  Forecast production profit / loss 7

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Production Quantity

$

Break-even Point

Fixed Costs

Variable Costs

Total Costs

Total Revenue

Loss

Profit

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Problem 8 A labor-intensive process has a fixed cost of $338,000 and a variable cost of $143 per unit. A capitol-intensive (automated) process for the same product has a fixed cost of $1,244,000 and a variable cost of $92.50. If the selling price for the product is $197, how many units must be sold to justify the automated process?

(A) 1

(B) 6259

(C) 11,904

(D) 17,940

PROBLEM 8

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$0

$500,000

$1,000,000

$1,500,000

$2,000,000

$2,500,000

$3,000,000

$3,500,000

$4,000,000

$4,500,000

0 5000 10000 15000 20000 25000 Units Produced

Cost of Labor-intensive Process

Cost of Automated

Process

Revenue

1,244,000 + 92.5x = 338,000 + 143x x = 17,940

1,244,000 + 92.5x = 197x x = 11,904

338,000 + 143x = 197x x = 6259

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Marginal and Average Costs - Marginal Costs: the variable cost for one

more unit of output

- Capacity Planning: Excess capacity

- Basis for last-minute pricing

- Average Costs: total cost divided by the total number of units produced.

- Basis for normal pricing

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Sunk Costs and Opportunity Costs -  Sunk Costs: Cost that has occurred in the past

and has no relevance to estimates of future costs and revenues related to an alternative

-  Purchasing price of current equipment in deciding new equipment (except for capital gain/loss consideration)

-  Opportunity Costs: Cost of the foregone opportunity and is hidden or implied

-  Existing equipment in replacement analysis

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Sunk Costs -  Note that people have a particular difficulty

ignoring sunk costs in decision making.

-  In the current housing crisis, many people’s houses are not worth what they were 2 years ago and they will not sell the house for what it is worth now.

-  Losing gamblers often keep gambling with the conviction that their luck must change in the future (Gambler’s ruin)

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Recurring and Incremental Costs -  Recurring Costs: Repetitive and occur when a firm

produces similar goods and services on a continuing basis

-  Office space rental

-  Non-recurring Costs: Not repetitive, even though the total expenditure may be cumulative over a period of time

-  Typically involve developing or establishing a capability or capacity to operate

-  Examples are purchase cost for real estate, and the construction costs of the plant

-  Incremental Costs: Difference in costs between two alternatives.

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Cash and Book Costs -  Cash Costs: Costs that involve money/cash

transaction

-  Interest payments, taxes, etc.

-  Book Costs: Costs that that do not involve money/cash transaction

-  Depreciation is charged for the use of assets, such as plant and equipment

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Life-Cycle Costs -  Life-Cycle Costs: Summation of all costs, both

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

-  Life cycle begins with the identification of the economic needs or wants (the requirements) and ends with the retirement and disposal activities.

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Cost Estimating -  Until a cost is incurred, it can only be estimated

– as a result most economic analysis is based on estimates.

-  Engineers need to be good at estimating a variety of parameters – this includes engineering students.

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Some Things to Remember about Estimation

-  Experience often plays a big role in estimating. Be careful when discounting the estimates of people who have more experience than you do.

-  Because estimation is often subjective, bias can often effect estimates. Be careful when interpreting estimates from people who have a clear reason for providing biased values.

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Methods of Estimation -  Bound the upper and lower limits of a parameter

and then examine the assumptions of each.

-  Estimates should almost always be provided as an interval – statistical confidence interval.

-  Generalize from the a specific measurable event to a less specific non-measurable event.

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Problem 10 How much will the monthly payments be on a $20,000 car if the loan period if 48 months, and the interest rate is 5% (compounded monthly)

(A) $416.67

(B) $460.59

(C) $500.00

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Problem 11 How much money ($) is in the room?

(A) LESS THAN $10

(B) BETWEEN $10 AND $100

(C) MORE THAN $100

Cost Estimating Approaches -  Top-down Approach

-  Uses historical data from similar engineering projects

-  Modifies original data for changes in inflation, activity level, weight, energy consumption, size, etc…

-  Best use is early in estimating process

-  Bottom-up Approach

-  More detailed cost-estimating method

-  Attempts to break down project into small, manageable units and estimate costs, etc….

-  Smaller unit costs added together with other types of costs to obtain overall cost estimate

-  Works best when detail design is available

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Cash Flow Diagrams -  Summarizes costs & benefits occur over time

-  Illustrates the size, sign, and timing of individual cash flows

-  Components

-  A segmented time-based horizontal line, divided into time units

-  A vertical arrow representing a cash flow is added at the time it occurs

-  Arrow pointing down for costs and up for benefits

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Timing of Cash Flow Size of Cash Flow

At time zero (now) Positive $100 1 time period from today Negative $100 2 time periods from today Positive $100 3 time periods from today Negative $150 4 time periods from today Negative $150 5 time periods from today Positive $50

4 0 1 2 3 5

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Categories of Cash Flows -  First cost: expenses to build or to buy and install

-  Operations and maintenance (O&M): annual expense, such as electricity, labor, and minor repairs

-  Salvage value: receipt at project termination for sale or transfer of the equipment

-  Revenues: annual receipts due to sale of products or services

-  Overhaul: major capital expenditure that occurs during the asset’s life

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Drawing a Cash Flow Diagram -  Shows when all cash flows occur

-  The end of period t is the same time as the beginning of period t+1

-  Rent, lease, and insurance payments are usually treated as beginning-of-period cash flows

-  O&M, salvage, revenues, and overhauls are assumed to be end-of-period cash flows

-  The choice of time 0 is arbitrary

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