Cost Based Analysis

ENG 3000
© Nish Balakrishnan, 2020
Learning Objectives
• Be able to define basic costs (income, benefits, profit, etc…) and
know how to identify them in an analysis

• Correctly distinguish what sort of costs (such as sunk, opportunity,

and other costs) can or cannot be included in a cash flow

• Assess when a problem is “cost based” vs. “flow based”

• Be able to solve simple cost-based problems involving varying costs,

and also apply these costs to flow based problems.
Cost Based Problems
• So far, problems have been solved by modelling the time value of
money:
• Discounting and Interest based problems (Module 2)
• Problems using Cash Flows (Module 3)
• What about problems that don’t involve significant time spans?
• What about the individual costs in a problem?
Cost Based Problems
• Typically, these problems don’t involve a cash flow, and are based
on a single snapshot in time, or a short timeframe in general.
• Critical portion of economics, especially any industrial problems
involving production/manufacturing.
• Primarily involves the analysis of costs vs flows:
• Fixed Costs
• Variable Costs
• Opportunity Costs
• Sunk Costs
• Can also involve analysis:
• Break Even Point (BEP) analysis
• Linear Programming/Optimization
Cost Based Problems
Example: Your company produces cylinder heads for a variety of
industrial gasoline engines. Each new design you make costs $15000 to
set up, and to produce each head the costs are as follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until
you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for
$100.
What is the per head income and profit for each head, and how much
money is made if an order of 1200 Model A heads is placed and 1500
Model B heads? What is the break-even point for each model?
Cost Definitions
• Fixed Costs: typically costs that are not linked to variations in quantity,
fixed based on numbers generally.
– Examples: Venue Costs, Constant Overhead Costs, Constant Manufacturing Costs,
etc…
– Note: some fixed costs do vary with quantity but not proportionally (e.g., venue size)
• Variable Costs: typically costs that are linked to variations in quantity,
costs are variable with a specific quantity.
– Examples: Material Costs, Labor Costs, Manufacturing Costs, Packaging Costs,
Processing Costs, etc…
• Total Cost: sum of fixed + variable costs, total cost to make all of your
items (i.e. how much it costs to make 1200 cylinder heads)
• Unit Cost: cost per unit, total cost over number of units made (i.e. $28
per cylinder head)
Profit
Fixed Costs
Example: Your company produces cylinder heads for a variety of industrial gasoline
engines. Each new design you make costs $15000 to set up, and to produce each head
the costs are as follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for $100.

What are the Fixed Costs?

Variable Costs
Example: Your company produces cylinder heads for a variety of industrial gasoline
engines. Each new design you make costs $15000 to set up, and to produce each head
the costs are as follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for $100.

What are the Variable Costs per Unit?

Income / Profit
Example: Your company produces cylinder heads for a variety of industrial gasoline
engines. Each new design you make costs $15000 to set up, and to produce each head
the costs are as follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for $100.

What is the income from each head, and the total profit for making 200 heads? What
about 1200 of Model A, 1500 of Model B?
Income / Profit
Example: Your company produces cylinder heads for a variety of industrial gasoline
engines. Each new design you make costs $15000 to set up, and to produce each head
the costs are as follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for $100.

What is the income from each head, and the total profit for making 200 heads? What
about 1200 of Model A, 1500 of Model B?
Break Even Point
• You may want to solve the problem for the number of units required
to “Break Even”
• Represents the point where profit is zero, and any further units sold
will net profit.
• Very important calculation in most production ventures:
– Likely not worth pursuing if goal is sales and can’t meet the break even point
• Simple procedure if problem has only a single item varying: assign a
variable (lets call it n) to the quantity
– Solve for n such that total profit (i.e. total income – total costs) = 0
– If price breaks are present, may have to assume a quantity and go back if the
quantity is higher/lower than one of the price breaks.
• If the problem involves multiple variables (i.e. two items) determine
the relationship from one quantity to the other in terms of n
Break Even Point
Example: Your company produces cylinder heads for a variety of industrial gasoline
engines. Each new design you make costs $15000 to set up, and to produce each head
the costs are as follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for $100.

What is the break even point for Model A heads, assuming Model B is not produced:
Note: we will drop the $ sign and also use the convention of prices in 1000’s instead
Assume break even point is higher than 301 heads (i.e. use all the price breaks)
Break Even Point
Example: Your company produces cylinder heads for a variety of industrial gasoline
engines. Each new design you make costs $15000 to set up, and to produce each head
the costs are as follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for $100.

What is the break even point for Model A heads, assuming Model B is not produced:
Note: we will drop the $ sign and also use the convention of prices in 1000’s instead
Assume break even point is less than 301 heads (i.e. use some price breaks
Cost Considerations – Economies of Scale
Economies of Scale
• Simple concept: The larger the scale, the cheaper things get.
• Can be applied to almost any economic aspect:
• Example: Bulk buying: the more material you buy the cheaper it gets
(packaging, bulk rates, etc...)
• Common examples of economies of scale:
• Shipping, manufacturing costs, material costs, labor rates, etc...Think of
the simple example: Shipping one package across the Atlantic ocean vs
shipping on modern 50,000 TEU container ships.
Cost Considerations – Economies of Scale
Dis-economies of Scale
• Simple concept: The larger the scale, the more expensive things get
• Can be applied to almost any economic aspect:
• Example: Bulk buying: the more material you buy after a certain point, the more
expensive it gets (storage, transport, supply etc...)
• Common examples of dis-economies of scale:
• Infrastructure, manufacturing costs, labour availability, sales, etc...
• Think of the simple example: Growing a few cucumbers in your backyard vs
running a full scale industrial farm, what actually costs less?
Cost Considerations – Economies of Scale
General Concept of Scale:
• Balance between large scale and small-scale operations
• Sensitivity to demand
• Examples: Ocean Freight, Perishable Products, Designed Goods
Cost Considerations – Sunk Costs
• Money that has already been spent that has no tangible value that
can be recovered.
• Typically, these costs are non continuous costs and can consist of:
• Infrastructure
• Planning
• Marketing
• Research and Design
• In a strictly economical sense these costs are:

NOT CONSIDERED AS PART OF YOUR ANALYSIS

Cost Considerations – Sunk Costs
• The rationale behind this:
• Once a sunk cost has been spent, it can no longer be recovered, therefore it
doesn't represent a viable cost to consider.
• Sunk costs are often used to "create" a situation where other costs can be
incurred
Example: Your company produces cylinder heads for a variety of industrial gasoline
engines, and recently spent $300,000 on Research and Design for your new cylinder
heads. They recently bought a machine for $80,000 to produce these heads, and in order
to develop new designs they need to purchase another machine that is $200k. Each new
design you make costs $15000 to set up, and to produce each head the costs are as
follows:
• $30 in material (for the first 200 heads, decreasing by $6 every 100 heads until you hit $18 per head)
• $40 in labor (decreasing to 75% of that when you make more than 200 heads)
• $10 in overhead costs per head
• Model A heads sell for $150 but cost 1.5x as much labor, Model B heads sell for $100.
Practical Considerations – Sunk Costs
• Sunk cost can be unsettling:
• Logical to disregard spent money – hard to convince others
• Uncertainty in projects – sunk cost vs. potential benefit?
• Several examples of poor economic judgement based on this:
• Disregarding costs that do have tangible value
• Making short term decisions that are profitable, disregarding overall project
timeline
• Sunk Cost Fallacy (Daniel Kahneman, behavioural economics):
• Hershey Kiss Experiment (Dan Ariely)
• Dollar Auction
• Concorde Fallacy
Other Costs
• Opportunity Cost:
• Money (or other resources) spent on one option will limit ability to look at other
options
• “Cost” of selecting one alternative over another
• Salvage/Scrap Value
• Cost (or benefit) at the end of a products useful life
• “Scrap” value is typically the benefit to dispose (can be positive, zero, negative)
• “Salvage” or “Book” values are typically the benefit to sell at end of life
• Countless exceptions:
• Some items have high internal value, low external value (i.e. replacement
cost)
• Some items have higher market value than original (real estate)
• Some items have a negative market value (cost to dispose of)
• Entire module for this (Replacement/Depreciation)
Example Problems
Problem 1: Your company produces widgets at a rate of ~45,000 widgets per year. Your
cost to produce the widgets involves $20 per widget of material, $10 per widget in
assembly, and $2 in packaging. Every year, your machine maintence adds up to ~$23000,
and workers expenses totals $50000. What are the total fixed and variable costs for your
company? What price must you sell your widgets at to break even on them? What price
must you sell your widgets at to make $400,000 per year?
Example Problems
Problem 2: Your company produces widgets at a rate of ~45,000 widgets per year. Your
cost to produce the widgets involves $20 per widget of material, $10 per widget in
assembly, and $2 in packaging. Every year, your machine maintenance adds up to
~$23,000, and workers expenses totals $50,000. A large manufacturing conglomerate has
offered to produce your widgets for you at a rate of $500,000 for tooling and fixed costs
per year (for 30,000 widgets) and a cost of $50 per widget for more widgets. Is this more
profitable than you making them yourself if you sell the widgets for $38 each in both
cases? If you're only interested in maximizing return (%), what quantity/option represents
the best case if you can make less widgets?
Example Problems
Problem 3: Your company produces widgets at a rate of ~45,000 widgets per year. Your
cost to produce the widgets involves $20 per widget of material, $10 per widget in
assembly, and $2 in packaging. Every year, your machine maintenance adds up to
~$23,000, and workers expenses totals $50,000. A large manufacturing conglomerate has
offered to rent the equipment needed to make widgets. The machine costs about
$120,000 a year to operate based on historical records, and can completely cover all
other parts of manufacturing / packaging. If operated 8 hours a day, it can make 45,000
units a year. If all other costs are the same, what is the maximum you'd want to pay for a
yearly rental? Assume you sell the widgets in both cases for $38. What differences are
there between the options?
Example Problems
Problem 4: Your company produces widgets at a rate of ~45,000 widgets per year. It
costs you $73,000 a year in fixed costs and $32 per widget make them and you sell them
for $38 a widget. A large manufacturing conglomerate offered to rent the equipment
needed to make widgets. The machine costs about $120,000 a year to operate based on
historical records, and can completely cover all other parts of manufacturing / packaging.
If operated 8 hours a day, it can make 45,000 units a year. You had paid $1.2 million
dollars to rent it, but it turns out it didn't fit and you're presented with two options: return
the machine and get $600,000 back (losing the remainder) and then going back to your
old manufacturing setup, or paying an extra $800,000 to modify your building for the
machine to fit. What is the best option?
 Example Problems
Problem 5: You work for a company that recycles 3 types of batteries: Car batteries, Powersports batteries, and Marine
batteries. Each battery that is brought in has 3 things done to it: the casing plastic is reused to make new batteries, the
lead is recovered and reformed into new battery cores, and the acid (or glass mats) from the batteries are neutralized
and disposed of. Currently your company has been bringing in batteries of all types and sending them out to a recycling
company. This has typically provided you with a profit of $500 per year, but you’re exploring a better process in-house,
that you believe can break even in 1 year. After hiring an engineer student (for 1k for a week), you have the following
costs associated with recycling.
▪ For each powersports battery, you pay the customer $5 for bringing in the battery. It costs you $4 in labour to strip the
battery down, and you typically have 0.1kg of material to neutralize and you produce 0.1L of contaminated water from
washing. The battery will have a casing worth $1 in recycled plastic, you’ll typically get $15 in lead out of the battery as
well.
▪ For each car/marine battery, you pay the customer $10 for bringing in the battery ($15 if it’s a marine battery). It costs
you $11 in labor to strip the battery down, and you typically have 0.5kg of material to neutralize and you produce 0.4L of
contaminated water from washing. The battery will have a casing worth $10 in re-usable plastic, and you’ll typically get
$30 in lead out of the battery as well ($38 per battery for the marine ones)
▪ You pay $1 per L of contaminated water to dispose of it, and $3 per kg of material to neutralize.
▪ The overhead cost of this operation is about $100 per year.
▪ To handle the casings and lead, you have to pay a one-time fee of $500 for health and safety equipment for your
workers.
▪ To handle the workflow, you will have to pay a one-time fee of $100 for advertising and $50 for signage around your
shop to handle the operation.
If half of the batteries you get are car batteries, and the remaining half is split evenly between powersports and marine,
what is the break even point (in terms of total number of batteries, assuming the split is as described) for this operation?
If you bring in 500 batteries (total) each year, what is the overall profit?
Overview:
• Be able to define basic costs (income, benefits, profit, etc…) and
know how to identify them in an analysis
• Correctly distinguish what sort of costs (such as sunk, opportunity,
and other costs) can or cannot be included in a cash flow
• Assess when a problem is “cost based” vs. “flow based”
• Be able to solve simple cost-based problems involving varying costs,
and also apply these costs to flow based problems.