Fixed Variable Marginal Average

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1 Engineering Costs Classifications of costs Fixed - constant, unchanging Rent is constant Typically includes building leases, insurance, salaries and lighting costs. Variable - depends on activity level Typically vary with the level of production. Marginal - variable cost for the next unit Depends on the next unit Average - total cost/number of units Rent+ food+ +n/number of units

2 Engineering Costs Evaluating a set of feasible alternatives requires that many costs be analyzed. Examples include costs for: initial investment, new construction, facility modification, general labor, parts and materials, inspection and quality, training, material handling, fixtures and tooling, data management, technical support, as well as general support costs (overhead).

3 Engineering Costs For example, in a production environment a fixed cost, such as costs for factory floor space and equipment, remains the same even though the production quantity, number of employees, or level of work-in-process are varying. Labor costs are classified as a variable cost because they depend on the number of employees in the factory. Thus fixed costs are level or constant regardless of output or activity, and variable costs are changing and related to the level of output or activity.

4 Profit and Loss Terms In terms of costs and revenues there are three possible profit and loss points for a business activity. Breakeven: total revenue = total costs Just getting along Profit region: total revenue > total costs Putting money in the bank Loss region: total revenue < total costs Going into debt

5 Past (Sunk) Costs and Future (Opportunity) Costs Sunk cost These are costs that must be incurred no matter what the decision. These costs are not part of opportunity costs. They are money spent due to a past decision. We cannot do anything about these costs. Purchase price paid for a car two years ago Opportunity cost - Value of the next best alternative; total benefit of choosing the next best option. It is a benefit that is foregone by engaging a resource in a chosen activity instead of engaging that same resource in some other activity. We make a choice or decision Buying lunch instead of petrol for car Instead of opening his own shop, which would cost Rs.20,000 per month to run (explicit cost), B could have worked for Universal Traders for Rs, 15,000 per month (implicit cost). His opportunity cost is Rs. 15,000 (alternate wage) + R5,20, 000 (the amount he WOULDN T have to pay each month) = Rs.37,000/-

6 Costs Example Last year, H decided to open a box factory. H built the factory for Rs.22,00,000. Materials and wages required to make a box amount to 50 paise per box Before starting production, H was offered a job at Box Mart that paid 4,000 a month Classify H s costs (explicit, implicit, economic, accounting, and sunk) Solution Explicit Costs: Factory (Rs. 22 lacs historic cost) Production (50 paise /box ongoing cost) Implicit Costs: Forgone Wage (Rs.4,000/month) Sunk Costs= Factory (Rs. 22 lacs)

7 Accounting Costs Accountants are responsible for keeping track of the money that flows into and out of firms. They focus on explicit costs. Accounting Costs = Explicit Costs Economists & Accountants calculate costs differently: Economists are interested in studying how firms make production & pricing decisions. They include all costs Economic Costs = Explicit + Implicit Costs

8 Profit: Economists vs Accountants Economist s View Accountant s View Economic Profit Accounting Profit Revenue Implicit Costs Explicit Costs Economic Costs Explicit Costs Revenue

9 Decision Making -Example A distributor of electric pumps must decide what to do with a "lot" of old electric pumps that was purchased 3 years ago. Soon after the distributor purchased the lot, technology advances were made. These advances made the old pumps less desirable to customers. The pumps are becoming more obsolescent as they sit in inventory. The pricing manager has the following information.

10 Cost implications of the example Purchase Price 70,000 ->sunk cost Past decision Storage Cost 10,000 >sunk cost Past decision List price at the time of purchase 95,000 > old cost Past decision List price of new pumps 1,20,000 Past decision Price offered for old pumps 2 years back 55,000 (foregone opportunity) Past decision Current price offered for old pumps if sold 33,000 (market value) Present Opportunity

11 Cash Costs vs. Book Costs Cash costs - movement of money from one owner to another - also known as a cash flow. For example-payment this month on an auto loan. Book cost - cost of a past transaction that is recorded in an accounting book. For example-down payment recorded in your checkbook from last years automobile purchase.

12 Cost Estimating Economic analysis is future based. Costs and benefits in the future require estimating. Estimated costs are not known with certainty. The more accurate the estimate, the more reliable the decision. Estimating is the foundation of economic analysis.

13 Types of Estimates There are 3 general types of estimates: 1. Rough order of magnitude, used for high level planning, inaccurate, range from -30% to +60% of actual values. 2. Semi-detailed - based on historical records, reasonably sophisticated and accurate, -15% to +20% of actual values. 3. Detailed - based on detailed specifications and cost models, very accurate, within -3% to +5% of actual.

14 Estimating Models Model Explanation Per Unit Segmenting Uses a per unit factor. Rs/sq ft, Benefits/employee Divide problem into items, estimate each & sum. Cost Indexes Index number based on historical changes in cost. Power Sizing Triangulation Scaling previous known costs up or down (economies of scale). Looking at costs from several perspectives. Learning Curve Tracking cost improvements.

15 Estimating Benefits So far we have focused on cost terms and cost estimating. However, engineering economists must often also estimate benefits. Example benefits include sales of products, revenues from bridge tolls and electric power sales, cost reductions from reduced material or labor costs, reduced time spent in traffic jams, and reduced risk of flooding. These benefits are the reasons that many engineering projects are undertaken. The cost concepts and cost estimating models can also be applied to economic benefits.