IND

E 250 Fundamentals of Engineering Economy

W. Art Chaovalitwongse Lecture 19 03/05/12 (Ch. 8 Cost Concepts)

Chapter Opening Story

q Biodegradable PlasNc Made from Plants by Nature Works qCapacity: 300 million lbs of pellets a year qCost: 5 to 10% higher than regular plasNc boWles or $1.05 per pound. q At Issue: How to esNmate the producNon cost of biodegradable plasNc per pound?

Contemporary Engineering Economics, 5th ediNon, 2010

General Cost Terms

Manufacturing Costs Direct Raw Materials Direct Labor Manufacturing Overhead Nonmanufacturing Costs Overhead (indirect) MarkeNng AdministraNve FuncNons
Contemporary Engineering Economics, 5th ediNon, 2010

Various Types of Manufacturing Costs

Contemporary Engineering Economics, 5th ediNon, 2010

Classifying Costs for Financial Statements

(Time) Matching Concept: The costs incurred to generate parNcular revenue should be recognized as expenses in the same period that the revenue is recognized. Period Costs: Those costs that are matched against revenues on a Nme period basis Product Costs: Those costs that are matched against revenues on a product basis.
Contemporary Engineering Economics, 5th ediNon, 2010

Example
Period Costs: General and administraNve expenses MarkeNng expenses Insurance premiums Income taxes Nonmanufacturing costs Product Costs: Direct material costs Direct labor costs Manufacturing overhead

How the Period Costs and Product Costs Flow Through Financial Statement

Contemporary Engineering Economics, 5th ediNon, 2010

Cost Flows and ClassicaNons in a Manufacturing Company

Contemporary Engineering Economics, 5th ediNon, 2010

Example 8.1 Classifying Costs for Uptown Ice Cream Shop

Breakdown of Unit Cost Product Costs:

Period Costs:

Contemporary Engineering Economics, 5th ediNon, 2010

Cost ClassicaNon for PredicNng Cost Behaviors

Mixed#cost#behavior#

Deprecia@on#Expenses#($)#

Volume index The unit measure used to dene volume

Automobile miles driven GeneraNng plant kWh produced Stamping machine parts stamped Assembly Plant units assembled

6000# 5000# 4000# 3000# 2000# 1000# 0# 5# 15# 25# Miles#Driven#(Unit:#1,000)#

Cost Behaviors Fixed costs: The costs of providing a companys basic operaNng capacity - Remain constant over the relevant range Variable costs: Costs that vary depending on the level of producNon or sales - Increase or decrease proporNonally to the level of volume Mixed costs: Costs are xed for a set level of producNon or consumpNon, becoming variable ager the level exceeded - Increase or decrease ager maintaining a xed level of expense Average unit costs: acNvity cost per unit basis Fixed, Variable, Mixed
Contemporary Engineering Economics, 5th ediNon, 2010

Future Costs for Business Decisions

DierenNal (Incremental) cost
Costs that represent the dierences in total costs, which results from selecNng one alternaNve instead of other Cost behavior: Increase or decrease with the overall change that a company experiences by producing one addiNonal unit of good

Opportunity cost
The potenNal benet that is given up as you seek an alternaNve course of acNon Example: When you decide to pursue a college degree, your opportunity cost would include a 4-years potenNal earnings foregone

Sunk cost
Cost that has already been incurred by past acNons Economic ImplicaNons: Not relevant to future decisions Example: $500 spent to replace brakes last yearnot relevant in making a selling decision in the future

Marginal Costs
Added costs that result from increasing rates of outputs, usually by single unit Example: Cost of electricitydecreasing marginal rate

Contemporary Engineering Economics, 5th ediNon, 2010

IllustraNon of Full Cost Concept

Full Production Cost (or Inventory Cost)

Direct Material Cost

Prime Cost

Full Cost

=
Direct Labor Cost

=
Overhead Cost

+
Selling Cost

General and Administrative Cost

Contemporary Engineering Economics, 5th ediNon, 2010

Cost-Volume-Prot Analysis
Prot MaximizaNon for a Short-Run Period Prot FuncNon: TR and TC FuncNons:

Prot FuncNon:

OpNmum AcNvity Level:

ContribuNon Margin and Break-Even Sales

q Prot FuncNon:

q Break-Even Volume (units): marginal contribuNon = p - v q Break-Even Sales ($)

Marginal contribution rate =

Break-Even Chart
(Fixed Manufacturing Overhead)- (Depreciation) Fixed Selling and Administrative Expense Variable Selling and Administrative Expense Variable Mfg., Overhead Direct Labor

$600 500 Dollars (in thousands) 400 300 200 100 10 18

Point of Desired Profit

Desired Profit

on) ciati epre )- (D ead nse verh xpense Expe E mins ing O ctur Admins d Ad verhead an ufa Man ling and le Selling le Mfg., O ed b Variab abor (Fix xed Sel Varia irect L D Fi

Total Cost Line Cash Cost Line

Direct Material
20 30 40 50 60 Units of Product (in thousands)
Contemporary Engineering Economics, 5th ediNon, 2010

Useful Break-even Sales Formulas

Fixed Cost = F MCR = p - v
Sales&at&break+even&point&for&total&cost: Fixed&costs F QA = = Marginal&Contribution&Rate MCR Sales&at&break+even&point&for&cash&costs: Fixed&cost&+&Depreciation QB = MCR Sales&required&for&desired&pre+tax&profit&level: QC = Fixed&costs&+&Desired&Profit MCR

($)
De p

ion iat rec

QB
ro dp fit

QA

QC
Sales Volume

s De

ire

Contemporary Engineering Economics, 5th ediNon, 2010

Cost Data for Break-Even Chart

Fixed manufacturing overhead (including DepreciaNon of $10,000) = $70,000 Fixed Selling and AdministraNve Expenses = $30,000 Selling Price/Unit = $10 Desired Prot before Taxes = $100,000
Unit%Variable%Costs%
Direct%Materials% Direct%Labor% Variable%Manufacturing%Overhead% Variable%Selling%and%AdministraBve%Expenses% Total%Unit%Variable%Cost% $2.00% 1.00% 1.00% 1.00% $5.00%

Contemporary Engineering Economics, 5th ediNon, 2010

Eect of Variable Costs on Sales

Company 1
Number of Units Sold Unit Selling Price 70,000 $10.00

Company 2
70,000 $10.00

Company 3
70,000 $10.00

$200
Company 2

35% MCR

30% MCR
Company 1

$100 0 $100 $200 20 40 60 80 100

20% MCR
Company 3

Unit Variable Cost Unit Marginal Contribution % Marginal Contribution

Total Marginal Contribution Fixed Costs Net Profit (loss) before taxes

7.00 3.00 30%

$210,000 150,000 $60,000

6.50 3.50 35%

$245,000 150,000 $95,000

8.00 2.00 20%

$140,000 150,000 ($10,000)

Units of Product Sold (000s)

An increase in the selling price when variable costs are fixed has the same effect of increasing MCR.

The Prot/Volume Graph shows prots (losses) at dierent operaNng levels for the three companies
Contemporary Engineering Economics, 5th ediNon, 2010

Eect of Fixed Costs

Financial Data:
Selling price per unit = $6.00 Variable cost per unit = $3.00 Unit marginal ContribuNon = $3.00 Current xed costs = $600,000 Desired prot level = $150,000 Required sales units = (600,000 + 150,000)/3 = 250,000 units
400
Profit and Loss ($)

200
0
100,000 200,000

200

Increase in sales units required to maintain the same level of profit

600 660 Fixed costs increase = $60,000 (ex. addiNonal adverNsing expenditure) Reqd. Sales units to maintain prots = 810,000/3 = 270,000 units

Contemporary Engineering Economics, 5th ediNon, 2010

Price ReducNon and Increase in Variable Costs

PRESENT
Present Operation Variable Cost Increase Selling Price Decrease

Unit Selling Price Unit variable Cost Unit marginal contribution Fixed Costs

$10.00 $7.50

$10.00 $8.25

$9.00 $7.50

Profits (000s)

10% increase in variable cost

10% reduction in sales price

$2.50 (25%) $1.75 (17.5%) $1.50 (16.6%) $150,000 $150,000 $150,000

0
Losses (000s)

150
60 86.7 100

Contemporary Engineering Economics, 5th ediNon, 2010

Example 8.4 Break-Even Analysis

q

Current Manufacturing OperaNon: A single shig ve-day work week: q Reached its maximum producNon capacity 24,000 units per week q Fixed cost - $90,000 per week q Avg. variable cost - $30 per unit q Need to produce 4,000 addiNonal units At Issue: Add overNme (and/or Saturday operaNons) or Second-shig operaNon q OpNon 1: Adding overNme or Saturday operaNons: $36/unit (36Q). Plants output = 36,000 units/week n OpNon 2: Second-shig operaNon: $13,000 + 31.50Q. Second shigs output = 21,000 units/week Break-even volume: n 36Q = $13,000 + 31.50Q n Q = 3,000 units

Example 8.7 Marginal Analysis

Financial Data: Unlimited demand Daily producNon capacity = 1,000 cases Fixed cost - $5,000 per week Variable cost: Product Mix: Marginal contribuNon for GA: $10 - $7 = $3 per case Marginal contribuNon for BA: $30 - $7 = $23 per case Schedule the product with the highest MC, i.e., Brand- name Aspirin Weekdays - $7 per case Marginal Analysis on Sunday OperaNon Sundays - $12 per case Marginal revenue - $10 per case Generic aspirin producNon: Marginal cost - $12 per case Unit price - $10 per case Sunday operaNon not economical Brand-name aspirin producNon: Break-Even Volume: Weekly demand 1,000 cases per week Unit price - $30 per case At Issue: (1) How to schedule the product mix and (2) Is it worth operaNng on Sundays?

Weekly Prots as a FuncNon of Time

Total Revenue and Cost FuncNons:
Schedule Brand-name aspirin rst Schedule Generic aspirin for 5 days Do not schedule anything on Sundays

Net Prot as a FuncNon of producNon Volume

CalculaNon of OperaNng Income

OperaNng revenue: The income earned by a business as a result of providing products or services to customers OperaNng expenses: The expenses incurred to generate the revenues of the specied operaNng period. OperaNng Income: The dierence between the operaNng revenue and operaNng expenses
Contemporary Engineering Economics, 5th ediNon, 2010

Manufacturing Business: Sales and ProducNon Budgets

Total annual volume = 5,000 units Unit sales price = $15

Desired ending inventory units to carry: 20% of the budgeted units Beginning inventory posiNon: 100 units

Contemporary Engineering Economics, 5th ediNon, 2010

The Budgeted Income Statement

Gross margin
= Gross income/Net sales = $31,580/$75,000 = 42.11%

OperaNng margin
= OperaNng income/Net sales = $13,890/$75,000 = 18.52%

Net prot margin

= Net income/Net sales = $9,029/$75,000 = 12.04%

Contemporary Engineering Economics, 5th ediNon, 2010