CHAPTER 2 - COST CONCEPTS

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1 ISE 2014 CHAPTER 2 - COST CONCEPTS Fixed/Variable Costs - If costs change appreciably with fluctuations in business activity, they are variable. Otherwise, they are fixed. A widely used cost model is: Total Costs = Fixed Costs + Variable Costs Recurring/Nonrecurring Costs - If costs are repetitive and occur when an organization produces goods or services on a continuing basis, they are recurring. Otherwise they are nonrecurring. Variable costs are recurring since they repeat with each unit of output. Direct/Indirect Costs - If costs can be reasonably measured and allocated to a specific output, they are direct. Otherwise they are indirect. 1

2 ISE 2014 CHAPTER 2 - COST CONCEPTS Overhead Costs - All costs of providing goods or services other than direct labor and direct material. Indirect costs are a subset of overhead costs. Fixed overhead relates more to plant capacity than production volume (variable overhead). Allocation of overhead to specific outputs may be in proportion to: 1. Direct labor hours 2. Direct material costs 3. Machine hours Cash Cost - Involves an actual cash payment. Book Cost - Reflected only in the accounting system. 2

3 ISE 2014 CHAPTER 2 - COST CONCEPTS Opportunity Costs - The cost of forgoing the chance to earn interest (or profit) on investment funds. Question: Is it in my best interest to keep my home because it is all paid for? I m a retired person living with my son, and I have rented my former home, valued at about $185,000, for $400 per month. Answer: There is little reason to continue owning your former home as a rental. To see this, consider the opportunity cost, i.e., the return you are giving up, of ownership. The same $185,000 invested in secure U.S. Treasury bonds at 7% will provide almost $13,000 in yearly income. This is many times what is obtained from continual rental. 3

4 ISE 2014 CHAPTER 2 - COST CONCEPTS Sunk Costs - Past costs that are unrecoverable and are not relevant for decision making purposes. Suppose the heating, ventilating and air conditioning (HVAC) system in your home has just experienced a major failure. You immediately call the Air Comfort Company for an estimate to replace your system. Their price is $4,200 and you gladly sign a contract and write a check for the required $1,000 down payment. At this point the weather warms and the urgency for replacement of your defunct system eases somewhat. You then get a second estimate for a new HVAC system. It is $3,000. You call Air Comfort back and they inform you that the $1,000 down payment is not refundable! What should you do? Explain. 4

5 ISE 2014 LIFE CYCLE COSTS (LCC) LCC are a summation of all the costs (and some revenues) over the entire life span of a structure, or system. All amounts are expressed in dollars that are time-equivalent (the subject of Chapter 3). General Formula: LCC = Investment Costs + Non-Fuel O&M and Repair Costs + Replacement Costs + Energy Costs + Disposal Costs - Salvage Value (if any) 5

6 THE GENERAL ECONOMIC ENVIRONMENT Consumer goods and services are those products or services that are directly used by people to satisfy their wants. Producer goods and services are used to produce consumer goods and services or other producer goods. Goods and services may be divided into two types, necessities and luxuries. The General Price-Demand Relationship establishes that as the selling price per unit increases (decreases) the demand for that product or service will decrease (increase). 6

7 THE GENERAL ECONOMIC ENVIRONMENT The relationship between price and demand can be expressed as a linear function: p = a - bd for 0 D a b D = a - p b where p = price per unit D = demand for the product or service (# of units) a = base (maximum) price (intercept on the price axis) b = slope of the price-demand line 1/b = amount by which demand increases for each unit decrease in price 7

8 Scenario I: General Price-Demand Relationship Price (p) p = a - bd Units of Demand (D) 8

9 THE GENERAL ECONOMIC ENVIRONMENT The Total Revenue Function TR = (price per unit) x (demand) = pd = (a - bd)d = ad - bd 2 for 0 D a b where p = price per unit D = demand for the product or service (# of units) a = base (maximum) price (intercept on the price axis) b = slope of the price-demand line 9

10 Example - problem 2-8 (p. 60) Given: Relationship between price and demand is: D = p (units/month) Fixed Cost (C F ) = $800/month Variable Cost per Unit (c v ) = $30/unit Assumptions: Find: All units produced will be sold a) D* = number of units produced to maximize profit b) Maximum profit per month for the product; and c) Range of profitable demand (production) in units/month 10

11 #2-8. Solution (part a): Profit = TR - C T = pd - C F - c v D solving for p: p = D Profit = (78-0.1D)D D = 48D - 0.1D Take first derivative and set = 0 dprofit/dd = D* = 0 D* = 48/0.2 = 240 units/month D* = 240 units/month 11

12 #2-8. Solution (part b): Using equation for profit from part a) and D* = 240, Profit = 48D - 0.1D Profit = Maximum Profit = 12

13 #2-8. Solution (part b): Using equation for profit from part a) and D* = 240, Profit = 48D - 0.1D Profit = 48(240) - 0.1(240) = $4,960 Maximum Profit = $4,960/month 13

14 #2-8. Solution (part c): Breakeven points occur when TR = C T (profit = 0) Profit = 48D - 0.1D = 0 = D 2-480D = 0 14

15 #2-8. Solution (part c) continued: Using the quadratic equation to solve, D' = 480 ± (480)2 4(1)(8000) 2(1) = 240 ± D 1 ' = or 18 units/month D 2 ' = or 462 units/month Profitable range of demand: 18 units/mo. D 462 units/mo. 15

IE4503 Engineering Economics. Instructor: Assoc. Prof. Dr. Rıfat Gürcan Özdemir Teaching Assistant: Nihan Topuk

IE4503 Engineering Economics. Instructor: Assoc. Prof. Dr. Rıfat Gürcan Özdemir Teaching Assistant: Nihan Topuk IE4503 Engineering Economics Instructor: Assoc. Prof. Dr. Rıfat Gürcan Özdemir Teaching Assistant: Nihan Topuk Course Objectives Understand cost concepts and how to make an economic desicion with present