CE2451 Engineering Economics & Cost Analysis · PDF fileCE2451 Engineering Economics & Cost Analysis Dr. M. Selvakumar Associate Professor Department of Civil Engineering Sri Venkateswara

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CE2451 Engineering Economics & Cost Analysis

Dr. M. Selvakumar

Associate Professor

Department of Civil Engineering

Sri Venkateswara College of Engineering

Objectives of this course

• The main objective of this course is to make the Civil Engineering

student know about the basic law of economics, how to organize a

business, the financial aspects related to business, different

methods of appraisal of projects and pricing techniques. At the end

of this course the student shall have the knowledge of how to start a

construction business, how to get finances, how to account, how to

price and bid and how to assess the health of a project.

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Unit 2: Cost and Break Even Analysis

Types of costing – traditional costing approach - activity base costing -

Fixed Cost – variable cost – marginal cost – cost output relationship in

the short run and in long run – pricing practice – full cost pricing –

marginal cost pricing – going rate pricing – bid pricing – pricing for a rate

of return – appraising project profitability –internal rate of return – pay

back period – net present value – cost benefit analysis – feasibility

reports – appraisal process – technical feasibility economic feasibility –

financial feasibility. Break even analysis - basic assumptions – break

even chart – managerial uses of break even analysis.


Cost and Break Even Analysis

Unit 5

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Types of Costing

Costing - Definition

• System of computing cost of production or of

running a business, by allocating expenditure

to various stages of production or to different

operations of a firm.


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Types of Costing

• There are different types are used in cost

accounting.

• Different types is used in different industries to

analyse and presenting for the purpose of

‘managerial decisions’.


Types of Costing

Marginal costing

Absorption costing

Standard costing

Historical costing


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MARGINAL COSTING


Marginal Costing

• In economics and finance, marginal cost is the

change in the total cost that arises when the

quantity produced has an increment by unit.


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Marginal Costing [MC] Curve


Marginal Costing

• That is, it is the cost of producing one more unit

of a good or commodity.


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Marginal Costing

• For example, suppose it costs Rs.1000 to

produce 100 units and Rs.1020 to produce 101

units. The MC of the 101st unit is Rs.20.


Uses of MC

• To determine the optimum selling price where

company can achieve expected profit.


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Uses of MC cont…

• To check the effect of reducing of current price

on profit.


Uses of MC cont…

• Choose of good product mix, for company

producing more than one product.


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ABSORPTION COSTING


Absorption Costing

• Absorption costing means that all of

the manufacturing costs are absorbed by the

units produced.


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Absorption Costing

• In other words, the cost of a finished unit

in inventory will include direct

materials, direct labor, and both

variable and fixed manufacturing

overhead.3/17/2015 19SVCE, Sriperumbudur

Absorption Costing

• As a result, absorption costing is also referred to

as full costing or the full absorption method.


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Absorption Costing

• Absorption costing is often contrasted with

variable costing or direct costing.



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Absorption Costing

• Under variable or direct costing, the fixed

manufacturing overhead costs are not allocated

or assigned to (not absorbed by) the products

manufactured.


Absorption Costing

• Variable costing is often useful for

management's decision-making. However,

absorption costing is required for

external financial reporting and for income tax

reporting.


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STANDARD COSTING


Standard Costing

• Standard costs are usually associated with a

manufacturing company's costs of direct

material, direct labour, and manufacturing

overhead.


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Standard Costing

• Rather than assigning the actual costs of direct

material, direct labour, and manufacturing

overhead to a product, many manufacturers

assign the expected or standard cost.


Standard Costing

• This means that a manufacturer's inventories

and cost of goods sold will begin with amounts

reflecting the standard costs, not the actual

costs, of a product.


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Standard Costing

• As a result there are almost always differences

between the actual costs and the standard

costs, and those differences are known

as variances.


Standard Costing

• If actual costs are greater than standard costs

the variance is unfavorable. An unfavorable

variance tells management that if everything

else stays constant the company's actual profit

will be less than planned.


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Standard Costing

• If actual costs are less than standard costs the

variance is favorable. A favorable variance tells

management that if everything else stays

constant the actual profit will likely exceed the

planned profit.


HISTORICAL COSTING


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Historical Costing

• A measure of value used in accounting in

which the price of an asset on the balance sheet

is based on its nominal or original cost when

acquired by the company.


Historical Costing

• Based on the historical-cost principle most

assets held on the balance sheet are to be

recorded at the historical cost even if they have

significantly changed in value over time.


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Historical Costing

• For example, say the main headquarters of a

company, which includes the land and building,

was bought for Rs.100,000 in 1925, and its

expected market value today is Rs. 20 million.

The asset is still recorded on the balance sheet

at Rs.100,000.


How to arrive final cost of a product/ service/ asset?


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TRADITIONAL COSTING APPROACH/ CONVENTIONAL APPROACH


Traditional Costing Approach

• The traditional method of cost accounting refers

to the allocation of manufacturing overhead

costs to the products manufactured.


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• The traditional method assigns or allocates the

factory's indirect costs to the items

manufactured on the basis of volume such as

the number of units produced, the direct labor

hours, or the production machine hours.



• By using only machine hours to allocate the

manufacturing overhead to products, it is

implying that the machine hours are the

underlying cause of the factory overhead.


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• Traditionally, that may have been reasonable or

at least sufficient for the company's external

financial statements.


ACTIVITY BASE COSTING (A.B.C)


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Activity Base Costing

• Activity based costing (ABC) was developed to

overcome the shortcomings of the traditional

method.



• Instead of just one cost driver such as machine

hours, ABC will use many cost drivers to allocate

a manufacturer's indirect costs.


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• A few of the cost drivers that would be used

under ABC include the number of machine

setups, the tones of material purchased or used,

the number of engineering change orders, the

number of machine hours, and so on.


FIXED COST & VARIABLE COST APPROACH


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Cost of Production

Short-run Total Cost

In the short run, one or more (but not all) factors of

production (land, labour, machinery and materials)

are fixed in quantity.


Cost of Production


Total Fixed Cost (TFC) refers to total obligation

incurred by the firm per unit of time for all fixed

inputs. Total Variable Cost (TVC) are the total

obligations incurred by the firm per unit of time for

all variable inputs it uses.3/17/2015 48SVCE, Sriperumbudur

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Cost of Production


i.e. Total Cost equal to TFC + TVC

Consider a hypothetical case for different quantities

(Q) of production as shown below:


Cost of Production

Q TFC TVC TC

0 60 0 60

1 60 30 90

2 60 40 100

3 60 45 105

4 60 55 115

5 60 75 135

6 60 120 180


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Cost of Production


0

50

100

150

200

0 1 2 3 4 5 6 7

Quantity Produced

Co

st

TFC

TVC

TC


Cost of Production

INFERENCE:

•TFC are constant regardless of the level of output

•TVC are zero, when the output is zero and rises

as output rises


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Cost of Production

INFERENCE:

•At every output level, TC equals TFC+TVC. Thus,

the TC curve has the same shape as the TVC

curve but everywhere above by an amount equal to

TFC


Cost of Production

Short-run Average Cost

Average Fixed Costs (AFC) equals to total fixed

cost divided by output. Average Variable Cost

(AVC) equals total variable costs divided by output.


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Cost of Production

Short-run Average Cost

Average Cost (AC) equals total cost divided by

output. AC also equals AFC+AVC. Marginal Cost

(MC) equals the change in TC or change in TVC

per unit change in output.


Cost of Production

Q TFC TVC TC AFC AVC AC MC

1 60 30 90 60 30 90

2 60 40 100 30 20 50 10

3 60 45 105 20 15 35 5

4 60 55 115 15 13.75 28.75 10

5 60 75 135 12 15 27 20

6 60 120 180 10 20 30 45


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Cost of Production

Typical Cost Curve for Production

0

20

40

60

80

100

0 1 2 3 4 5 6 7

Quantity Produced

Co

st

AFC

AVC

AC

MC


Cost of Production

Marginal Cost (MC)

0

10

20

30

40

50

0 1 2 3 4 5 6

Quantity Produced

Co

st


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Cost of Production

Note

•MC schedules are plotted halfway between

successive levels of output


Cost of Production

•While AFC curve falls continuously as output is

expanded, the AVC, the AC and MC curves are U-

shaped. The MC curve reaches the lowest point at

a lower level of output than either the AVC or AC

curve


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Cost of Production

The portion of MC intersects the AVC and AC at

their lowest points. This is so because whenever

extra or marginal amount added to total cost (or

variable cost) is less than the average of that cost,

the curve necessarily falls.


Cost of Production

Conversely, whenever the marginal amount added

to TC (or TVC) is greater than the average of TC,

the average cost rises.


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Cost of Production

AVC = AC – AFC

When

MC < AC AC curve fall continuously

MC = AC Minimum AC

MC > AC AC starts rising


Long Run Cost

Long-run is the time period long enough for a firm

to be able to vary the quantity used of all inputs.

Thus, in the long-run, there are no fixed factor and

hence no fixed cost and the firm can build any size

or scale of plant.


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Long Run Cost

The Long-run Average Cost (LAC) curve shows the

minimum per unit of cost of producing each level of

output when any defined scale of plant can be built.


Long Run Cost

LAC is given by a curve tangential to all the short-

run average cost (SAC) curves representing all the

alternative plant sizes that the firm could built in the

long-run.


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0.0

5.0

10.0

15.0

20.0

25.0

0 2 4 6 8 10 12 14

Quantity

Avera

ge C

ost

SAC-1

SAC-2

SAC-3

SAC-4


Long Run Cost

If the firm expected to produce 2 units of output per

unit of time it would built the scale of plant given by

SAC-1 and operate it at point A where AC is 17.


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Long Run Cost

we could have drawn many more SAC curves in

the figure one for each alternative scales of plant

that the firm could built in the long run. By then

drawing a tangent to all these SAC curves, we

could get the LAC curve.


Shape of Curve

While the SAC curve and the LAC curve have been

drawn as U-shaped, the reason for their shapes is

quite different.


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Shape of Curve

The SAC curves decline at first, but eventually rise

because of the LAW of Diminishing Marginal

Returns (resulting from the existence of fixed inputs

in the short-run)


FULL COST PRICING


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Full Cost Pricing

It is a ‘price-setting method’ in which you add:

direct material cost + direct labor cost + selling cost

+ administrative costs + overhead costs

+ markup percentage (profit) in order to derive the

price of the product.


Full Cost Pricing

This method is most commonly used in situations

where products and services are provided based

on the specific requirements of the customer.


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Advantages Full Cost Pricing

It is simple

Likely to get profit

Justifiable


MARGINAL COST PRICING


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Marginal Cost Pricing

Marginal cost pricing is the practice of setting the

price of a product at or slightly above the variable

cost to produce it.



This situation usually arises in one of two

circumstances:

•A company has a small amount of remaining

unused production capacity available that it

wishes to use; or

•A company is unable to sell at a higher price


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The first scenario is one in which a company is

more likely to be financially healthy - it simply

wishes to maximize its profitability with a few more

unit sales.



The second scenario is one of desperation, where

a company can achieve sales by no other means.


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GOING RATE PRICING


Going Rate Pricing

Setting a price for a product or service using the

prevailing market price as a basis.


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Going Rate Pricing

Going rate pricing is a common practice

with homogeneous products with very

little variation from one producer to another, such

as aluminum or steel.


BID PRICING


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Bid Pricing

Price offered by bidder (contractor, supplier,

vendor) for a specific good, job, or service,

and valid only for the specified period.


PRICING FOR A RATE OF RETURN


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Pricing for a Rate of Return

Rate of return pricing is practiced by businesses

that set specific goals for the capital that they

spend and the revenue they wish to generate.



A business can set prices to ensure that these

goals will be achieved.


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This method of pricing is most effectively achieved

when a company has little or no competition in the

market, since the actions of competitors will likely

affect the rate of return (monopolistic).


APPRAISING PROJECT PROFITABILITY


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Appraising Project Profitability

Project appraisal is the process of assessing and

questioning proposals before resources are

committed.



Project appraisal is the process of assessing and

questioning proposals before resources are

committed.


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Project appraisal helps project initiators and

designers to;

•Be consistent and objective in choosing

projects

•Make sure their program benefits all sections of

the community, including those from ethnic

groups who have been left out in the past3/17/2015 93SVCE, Sriperumbudur


Project appraisal helps project initiators and

designers to;

•Provide documentation to meet financial and

audit requirements and to explain decisions to

local people.


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INTERNAL RATE OF RETURN


Internal Rate of Return

IRR calculations are commonly used to evaluate the

desirability of investments or projects.

The higher a project's IRR, the more desirable it is to

undertake the project.

Assuming all projects require the same amount of up-front

investment, the project with the highest IRR would be

considered the best and undertaken first.3/17/2015 96SVCE, Sriperumbudur

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Given a collection of pairs (time, cash flow) involved in a

project, the internal rate of return follows from the net

present value as a function of the rate of return. A rate of

return for which this function is zero is an internal rate of

return.



where,

NPV - Net Present Value

Cn - Cash flow at time ‘n’

r - rate of return

n - time period, years


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Year (n) Cash Flow, Cn

0 -123400

1 36200

2 54800

3 48100

%96.5

0)1(

48100

)1(

54800

)1(

36200123400

321

r

rrrNPV


PAY BACK PERIOD


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Pay Pack Period

Payback period in capital budgeting refers to

the period of time required to recoup the funds

expended in an investment, or to reach the break-

even point.


Pay Pack Period

For example, a Rs.1000 investment which returned

Rs. 500 per year would have a two-year payback

period. The time value of money is not taken into

account.


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COST-BENEFIT ANALYSIS


Cost-Benefit Analysis

Broadly, CBA has two purposes:

1. To determine if it is a sound

investment/decision (justification/feasibility)

2. To provide a basis for comparing projects. It

involves comparing the total expected cost of

each option against the total expected

benefits, to see whether the benefits

outweigh the costs, and by how much.3/17/2015 104SVCE, Sriperumbudur

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Cost-Benefit Analysis

The CBA is also defined as a systematic process

for calculating and comparing benefits and costs of

a project, decision or government policy / project.


FEASIBILITY REPORT


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Feasibility Report

The feasibility study is an evaluation and analysis

of the potential of a proposed project which is

based on extensive investigation and research to

support the process of decision making.


Feasibility Report

A well-designed feasibility study should provide a

historical background of the business or project, a

description of the product or service, accounting

statements, details of

the operations and management, marketing

research and policies, financial data, legal

requirements and tax obligations.


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Feasibility Report

Generally, feasibility studies precede technical

development and project implementation.


BREAK EVEN ANALYSIS


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Break Even Analysis

Number of units that must be sold in order to

produce a profit of zero (but will recover all

associated costs). In other words, the break-even

point is the point at which your product stops

costing you money to produce and sell, and starts

to generate a profit for your company.


Break Even Analysis


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Break Even Analysis

)(

)(

VP

TFCX

TFCVPX

TFCXVXP

XVTFCXP

TCTR

TR-Total Revenue;

TC-Total Cost;

P-Price per unit;

X-No. of units;

V-Variable Cost;

TFC-Total Fixed Cost


Break Even Analysis

The quantity, , is of interest in its own right, and is

called the Unit Contribution Margin (C): it is the

marginal profit per unit, or alternatively the portion

of each sale that contributes to Fixed Costs. Thus

the break-even point can be more simply computed

as the point where Total Contribution = Total Fixed

Cost.


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THE END


Documents

CE2451 Engineering Economics & Cost Analysis · PDF fileCE2451 Engineering Economics & Cost Analysis Dr. M. Selvakumar Associate Professor Department of Civil Engineering Sri Venkateswara