IE 303

Chapter 2
Cost Concepts and Design Economics
 Cost Terminology
• Fixed Costs are those unaffected by changes in activity
level over a feasible range of capacity available.
– Typical fixed costs include insurance and taxes on facilities,
general management and administrative salaries, license
fees, and interest costs on borrowed capital..

• Variable Costs are those associated with an operation

that varies 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
 Cost Terminology
• Incremental cost is the additional cost resulting
from increasing the output 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 $0.49 / mile. This cost depends on:
• mileage driven;
• mileage expected to drive;
• age of car
 Cost Terminology
• Direct Costs: Can be reasonably measured and
allocated to a specific output or work activity. (e.g.
labor, material costs directly allocated to a product)

• Indirect Costs (Overhead Cost): Difficult to allocate

to a specific output or work activity. (e.g. general
supplies, equipment maintenance, electricity,
administrative costs)

• Standard Costs: Cost per unit output, calculated

before production or service delivery
 INDIRECT AND OVERHEAD COSTS

Overhead consists of plant operating

costs that are not direct labor or
material costs
- indirect costs, overhead and burden are the
same;
 Cost Terminology
• Cash Cost: Involves payment of cash and
results in cash flow

• Book Cost: is a payment that does not involve

cash transaction; book costs represent the
recovery of past expenditures over a fixed
period of time. (e.g. depreciation cost)
– Affects income taxes that is related to cash flows

• Sunk Cost: is one that has occurred in the past

and has no relevance to estimates of future
costs and revenues.
RECURRING AND NONRECURRING
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
RECURRING AND NONRECURRING
COSTS
• Nonrecurring costs are those that are not
repetitive,

• Examples are purchase cost for real estate

upon which a plant will be built, and the
construction costs of the plant itself;
 Cost Terminology
• Opportunity Cost: Cost of the best rejected or
missed opportunity.
– Example: When you buy a car with 50.000 TL, your
opportunity cost is the interest that you could
earn with this 50.000 TL from a bank account.
 Cost Terminology
• Life-cycle cost: Summation of all the costs,
both recurring and nonrecurring, related to a
product, structure, system, or service during
its life span.
– Investment cost, working capital, operation and
maintenance cost, disposal cost.
Figure 2-1 Phases of the Life Cycle
and Their Relative Cost
 Life-cycle costs
• Investment Cost or capital investment is the capital
(money) required for most activities of the
acquisition phase;
• Working Capital refers to the funds required for
current assets needed for start-up and subsequent
support of operation activities;
• Operation and Maintenance Cost includes many of
the recurring annual expense items associated with
the operation phase of the life cycle;
• Disposal Cost includes non-recurring costs of shutting
down the operation;
 Price – Demand relationships

Scenario 1: Demand is a function of price

As the selling price (p) of a product or service is
increased, there will be less demand (D) for the
product or service.

Scenario 2: Price is independent of demand

 Scenario 1: Demand is a function of price
Figure 2-2 General Price–Demand Relationship. (Note that price
is considered to be the independent variable but is shown as the
vertical axis. This convention is commonly used by economists.)

a is intercept on the price axis

-b is the slope (the amount by which

demand increases for each unit
decrease in p)
 Total Revenue
TR = price x demand = p . D
p = a – bD 

TR = (a – bD) D = aD – bD2
dTR /dD = a – 2bD = 0
D’ : demand for maksimum total revenue
D’ = a / 2b
Figure 2-3 Total Revenue Function as a Function of Demand
 Figure 2-4 Combined Cost and Revenue Functions, and
Breakeven Points, as Functions of Volume, and Their Effect on
Typical Profit

Profit is
maximum
where
Total
Revenue
exceeds
Total Cost
by greatest
amount

D1’ and D2’

are
breakeven
points
 Cost, Volume, Breakeven Point relationships

Total Cost = Fixed cost + Variable Cost

CT = C F + C V
Variable cost (CV) = Variable cost per unit x Demand
CV = c v . D
Total Cost = Fixed cost + Variable Cost
CT = C F + C V = C F + c v . D
Profit (loss) = total revenue – total cost
Profit (loss) = (aD – bD2) – (CF + cv . D)
Profit (loss) = – bD2 + (a – cv)D - CF
 PROFIT MAXIMIZATION (D*)
Profit (loss) = – bD2 + (a – cv)D - CF

In order for a profit to occur two conditions

must be met:

1- (a – cv) > 0 that is (a > cv) which means the

price per unit that will result in no demand (a) is
greater than varible cost per unit (cv). This avoids
negative demand.

2- Total revenue must exceed total cost.

 PROFIT MAXIMIZATION (D*)
Profit (loss) = – bD2 + (a – cv)D - CF

Profit maximization occurs where total revenue exceeds

total cost by the greatest amount;
It occurs where
d(profit) / dD = 0;
d(profit) / dD = (a – cv) – 2bD = 0

 D* = [ a - Cv ] / 2b
 PROFIT MAXIMIZATION (D*)
For a true maksimum point, the second
derivative must be negative:

d2(profit) / d2D = - 2b

If b > 0 then -2b is negative, that means the

solution is a real maximum point.
 BREAKEVEN POINT
D’1 and D’2
Occurs where Total revenue = Total Cost (Ct)
( aD - bD2 ) = CF + (cv) D
- bD2 + [ a - cv ] D - CF = 0
This equation is quadratic equation with one unknown.
Using the quadratic formula we can find breakeven points
D’1 and D’2 :

- [ a - cv ] + { [ a - cv ] 2 - 4 (- b ) ( - CF )}1/2
D’ = -----------------------------------------------------
2 (- b)
Figure 2-5 Spreadsheet Solution,
Example 2-4
 Figure 2-5 (continued)
Spreadsheet Solution, Example 2-4
Figure 2-6 Typical Breakeven Chart with Price (p) a Constant
(Scenario 2): Price is independent of demand

TR = p . D
 Engineers must consider cost in
the design of products, processes
and services.

• “Cost-driven design optimization” is critical

in today’s competitive business
environment.
 Two main tasks are involved in cost-
driven design optimization.
1. Determine the optimal value for a certain
alternative’s design variable.
2. Select the best alternative, each with its own
unique value for the design variable.

Cost models are developed around the design

variable, X.
 Optimizing a design with respect to
cost is a four-step process.
• Identify the design variable that is the primary cost
driver.
• Express the cost model in terms of the design variable.
• For continuous cost functions, differentiate to find the
optimal value. For discrete functions, calculate cost
over a range of values of the design variable.
• Solve the equation in step 3 for a continuous function.
For discrete, the optimum value has the minimum
cost value found in step 3.
 Here is a simplified cost function.

where,
a is a parameter that represents the directly varying cost(s),
b is a parameter that represents the indirectly varying
cost(s),
k is a parameter that represents the fixed cost(s), and
X represents the design variable in question.
or Crew’s time
 PRESENT ECONOMY STUDIES
When alternatives for accomplishing a task are compared
for one year or less (I.e., influence of time on money is
irrelevant)
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
 PRESENT ECONOMY STUDIES

Total Cost in Material Selection

In many cases, selection among materials cannot be
based solely on costs of materials. Frequently, change
in materials affect design, processing, and shipping
costs.
 PRESENT ECONOMY STUDIES
Alternative Machine Speeds
Machines can frequently be operated at
different speeds, resulting in different rates of
product output. However, this usually results
in different frequencies of machine downtime.
Such situations lead to present economy
studies to determine preferred operating
speed.
 PRESENT ECONOMY STUDIES
Make Versus Purchase (Outsourcing) Studies
A company may choose to produce an item in house, rather
than purchase from a supplier at a price lower than
production costs if:
1. direct, indirect or overhead costs are incurred regardless of
whether the item is purchased from an outside supplier, and
2. The incremental cost of producing the item in the short run is
less than the supplier’s price
The relevant short-run costs of the make versus
purchase decisions are the incremental costs
incurred and the opportunity costs of resources
 PRESENT ECONOMY STUDIES
Make Versus Purchase (Outsourcing) Studies
• Opportunity costs may become significant
when in-house manufacture of an item
causes other production opportunities to be
foregone (E.G., insufficient capacity)
• In the long run, capital investments in
additional manufacturing plant and capacity
are often feasible alternatives to outsourcing.
 Some Reasons For Making:
• Lower production cost
• Unreliable or unsuitable suppliers
• Assure adequate supply (quantity)
• Utilize surplus labor capacity
• Obtain desired quality
• Protect special design or quality

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 Some Reasons For Buying:

• Lower acquisition cost

• Inadequate capacity
• Reduce inventory costs
• Ensure alternative sources of supply
• Item is protected by a patent or trade
license

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