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COST TERMINOLOGY
There are variety of costs to be considered in an engineering economy analysis. These costs differ in their frequency of occurrence, relative magnitude, and degree of impact on the study.
Engineering economic analysis is primarily concerned with comparing alternative projects. The comparison process utilises a variety of cost terminologies and cost concepts. Cost terminology: life-cycle costs Sunk costs Opportunity costs Direct, indirect, and standard costs Fixed and variable costs Incremental costs.
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LIFE-CYCLE COST
Life-cycle cost is the summation of all costs, both recurring and nonrecurring, related to a product, structure, system, or service during its life span.
Acquisition phase:
1. 2. 3.
Life cycle costs: First cost (initial investment) Operating and maintenance costs Disposal cost
Production
Operation
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Retirement
Ex: a purchase of machine tool, the first cost may consist of the following elements: Basic machine cost Cost of training personnel Shipping and installation costs (installation costs: foundation,
vibration and noise insulation, light and power supply, testing and commissioning costs)
Initial tooling costs Supporting equipment costs (computer control ware, spare parts
inventory)
Some projects may include working capital for inventories, cash for wages, materials, etc. Working
Capital refers to the funds required for current assets needed for start-up and subsequent support of operation activities;
Operating and maintenance costs These are recurring costs that are required to operate and maintain the item during its useful life. Labour Material Overheads: water and electricity, insurance, inventory, indirect labour,
administrative and management expenses.
Disposal cost This situation occurs when the life cycle of an item has ended. Labour and material costs for removal of the item Shipping cost Special costs (disposing of hazardous materials)
SUNK COST
A sunk cost is one that has occurred in the past and it is unrecoverable. It has no relevance to decisions because it cannot be changed regardless of what decision is made now or in the future. Example: Let say you have spent RM3 million on a project that requires another RM2 million for completion (you are contemplating to proceed), You recently determined the project would bring in RM3 million. Do you proceed? Yes, Absolutely. The first RM3 million is gone (sunk cost), no matter what you do. The next RM2 million investment will, in effect generate a 50% return {(3-2)/2*100%}.
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 another alternative use is foregone. Example: Consider an employee who could earn RM25,000 for working during a year but chooses instead to go to college for a year and spend RM10,000 to do so. The opportunity cost of going to college for that year is RM35,000; (RM10,000 cash outflow and RM25,000 for income foregone)
Direct costs can be reasonably measured and allocated to a specific output or work activity --- labor and material directly allocated to a
product, service or construction activity;
Indirect costs are difficult to allocate to a specific output or activity --- costs of common
tools, general supplies, and equipment maintenance ;
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OVERHEAD COSTS
Overhead costs consist of all costs of manufacturing other than direct labor and direct material costs --- insurance premium, rent,
maintenance and repairs, supervisory and administrative personnel, utilities, depreciation.
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FIXED COSTS
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.
When large changes in usage of resources occur, or when plant expansion or shutdown is involved fixed costs will be affected.
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VARIABLE COSTS
Variable costs are those associated with an operation that vary in total with the quantity of output or other measures of activity level. Example of variable costs include : costs of
material and labor used in a product or service, because they vary in total with the number of output units -- even though costs per unit remain the same.
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Conversion costs
Selling price
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RM Work in progress 18,500 Cost of raw materials 1,850,000 Production wages 850,000 PRIME COST 2,700,000 FACTORY OVERHEAD EXPENSES: Acids and diesel 53,000 Electricity and water 108,900 Repair and maintenance 158,000 Depreciation 150,000 Indirect wages 90,500 Insurance 38,100 Labour safety and attire 17,200 Medical 12,000 Staff training 10,000 637,700 3,337,700 3,356,200 Less: Work-in-progress 12,090 COST OF PRODUCTION 3,344,110
Manufacturing Account
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RECURRING COSTS
Recurring costs are repetitive and occur when a firm produces similar goods and services on a continuing basis. Variable costs are recurring costs because they repeat with each unit of output . A fixed cost that is paid on a repeatable basis is also a recurring cost: Office space rental
NONRECURRING COSTS
Nonrecurring costs are those that are not repetitive, even though the total expenditure may be cumulative over a relatively short period of time; Examples are purchase cost for real estate upon which a plant will be built, and the construction costs of the plant itself;
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INCREMENTAL COSTS
incremental cost is the additional cost that results from increasing the output of a system by one unit. Incremental cost is often associated with go / no go decisions that involve a limited change in output or activity level. EXAMPLE the incremental cost of driving an automobile might be $0.27 / mile. This cost depends on: mileage driven; mileage expected to drive; age of car;
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Consumer goods and services are those that are directly used by people to satisfy their wants; Producer goods and services are those used in the production of consumer goods and services: machine tools, factory buildings, buses and farm machinery are examples;
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Suppliers:
Technology, Machines and Equipment, Services, Contractors
TNB
Consumers: Households, Industries, Commercial Complexes, Administrative Complexes, Schools, Hospitals, etc.
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Demand Curve
The law of demand when price increases, quantity demanded will reduce, vice versa.
Price (p)
From the point of view of consumers
D
Important assumption: Price is the only factor influencing the buyers decision to maximize their satisfaction
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Quantity (D)
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Supply Curve
The law of supply when price increases, quantity supplied will increase, vice versa.
Price (p)
S
Important assumption: Price is the only factor influencing the suppliers decision to maximize profits
Quantity (S)
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PRICE
QUANTITY ( D )
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PRICE
Price equals some constant value minus some multiple of the quantity demanded: p=a-bD
QUANTITY ( D )
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PRICE
Price equals some constant value minus some multiple of the quantity demanded: p=a-bD a = Y-axis (quantity) intercept, (price at 0 amount demanded); b = slope of the demand function;
QUANTITY ( D )
The relationship between price and demand can be expressed as the linear function p = a - b D
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PRICE
Price equals some constant value minus some multiple of the quantity demanded: p=a-bD
a = Y-axis (quantity) intercept, (price at 0 amount demanded);
D = (a p) / b
QUANTITY ( D )
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PRICE a
Price equals some constant value minus some multiple of the quantity demanded: p=a-bD a = Y-axis (quantity) intercept, (price at 0 amount demanded); b = slope of the demand function; D = (a p) / b
MR=0
QTY
Total Revenue
PRICE
Price equals some constant value minus some multiple of the quantity demanded: p=a-bD a = Y-axis (quantity) intercept, (price at 0 amount demanded); b = slope of the demand function;
MR=0 QTY
Total Revenue
D = (a p) / b
TR = Max
QTY
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Cost / Revenue
Maximum Profit
Cost / Revenue
Cf
D1
PROFIT MAXIMIZATION D*
Occurs where total revenue exceeds total cost by the greatest amount; Occurs where marginal cost = marginal revenue;
D* = [ a - (Cv) ] / 2b
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Rules for Selecting Preferred Alternative Rule 1 When revenues and other economic benefits are present and vary among alternatives, choose alternative that maximizes overall profitability based on the number of defect-free units of output
Rule 2 When revenues and economic benefits are not present or are constant among alternatives, consider only costs and select alternative that minimizes total cost per defect-free output
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1.
2.
Opportunity costs may become significant when in-house manufacture of an item causes other production opportunities to be foregone (ex: insufficient capacity)
In the long run, capital investments in additional manufacturing plant and capacity are often feasible alternatives to outsourcing.
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