ENGINEERING ECONOMY BPK 30902 Chapter 2

Prepared by: Dr.S.Thamizhmanii

PRODUCTION
It

is process to convert raw materials into useful quality products.

COST CONCEPT

Cost or expense word has different meaning in usage.

COST TERMINLOY
Cost estimation is total cost of project with certain assumptions and include total amount spent. Estimation is based on engineering design and forecast of the business. It is difficult job to ascertain the cost as estimate. Cost estimation is integral part of a comprehensive planning and design process requiring the active participation of not only engineering designers but also personnel from marketing, manufacturing, finance and top management.

COST TERMINLOY

Reasons for cost estimation: 01. Providing information used in setting a selling price, bidding, or evaluating contracts. 02. To determine whether a product can be produced and sellable in the market with profit. 03. Helps to justify how much money can be spent on project, change of process, and for other improvements. 04. Establish benchmarks for productivity programs.

COST TERMINLOY
Two

approach for cost estimation. They

are: 01. Bottom up 02. Top down

COST TERMINLOY
BOTTOM

UP: Product costs are associated with direct or indirect costs. Direct costs are easily assignable to a specific product, while indirect costs are not easily allocated to a product. Ex. Direct cost would be the wages of a machine operator, indirect costs would be supervision.

COST TERMINLOY
Bottom

up: It is more detailed method of approach. It is break down into small units, manageable units and to estimate their economic consequences. These smaller units are added with other type of cost to obtain overall cost estimate.

COST TERMINLOY
The

bottom up approach is used because the procedure requires require estimate of cost elements at the lower levels of the cost structure which are then added together to obtain the total cost of the product.

COST TERMINLOY
Top

down: It uses past data from engineering projects to estimate the costs, revenues, and other data for the current project by modifying the data to suit inflation, deflation, activity level, weight, energy consumption, size and other factors. It can be used where alternatives are still being developed and refined.

TOP DOWN APPROACH

Design

to price: Estimation of selling price is obtained by accumulating relevant fixed and variable costs and then adding profit margin, which is a percentage of total manufacturing costs. This is termed as Design to price. (By American Companies).

TOP DOWN APPROACH

Japanese

companies apply the concept of target costing, which is a top down approach. Target costing is what should be the product cost instead of what does the product cost. Target costing is initiated by conducting market surveys to determine the selling price of the best competitors product.

TOP DOWN APPROACH

Target Cost = Competitors price Desired profit

Target cost = Competitors price / (1+ profit margin in terms of percentage) Target cost is obtained prior to the design of the product and is used as a goal for engineering design, procurement and production.

TOP DOWN APPROACH

If

a product is sold in the market at RM 27.50 per piece, the profit margin is 10 % expected, the target price is = 27.50 / (1+0.10) = RM 25.00

Target

TOP DOWN APPROCH

A

estimate for 4 year degree in an university can be done as follows. Cost of attending the first year degree is RM 8250.00 which include tuition fee, housing and meals. The inflation rate is 6% per year. The other costs remain RM 2000 per year.

TOP DOWN APPROCH

Year 1 2 3 4 Tuition fee, boarding Other and lodging expenses 8250 x 1.06 = 8745 2000 8745 x 1.06 = 9270 9270 x1.06 = 9826 10415 x 1.06 = 11040 Total 2000 2000 2000 Total cost estimated 10745.00 11270.00 11826.00 13040.00 46881.00

TYPES OF COSTS

01. Fixed cost, 02. Variable cost, 03. Incremental cost, 04. Direct cost (prime cost), 05. Indirect cost (over head cost), 06. Standard cost, 07. Sunk cost, 08. Opportunity cost, 09. Cash cost Versus book cost

FIXED COST
Fixed

costs: It is those costs are unaffected by any changes in the organization. It includes insurance and taxes on facilities, general management and administrative salaries, license fees and interest costs on borrowed capital. It tend to remain constant for specific period of time. This cost may change when investment is more and any changes occur due to expansion.

FIXED COST
The portion of the total cost that remains constant regardless of output levels e.g. land, property taxes, insurance, equipment, and building

VARIABLE COST
The portion of the total cost that varies directly with the volume of output. This includes direct material cost, labor cost and direct expenses. This varies with volume of production. e.g. labor, materials, transportation, and variable overhead

Example- The costs of material and labor used in a product or service are variable costs, because they vary in total with the number of output units, even though the cost per unit stay the
same.

INCREMENTAL COST / INCREMENTAL REVENUE It

is the additional cost that results from increasing the output of a system by one or more units.

DIRECT COSTS
Those

costs are that can be reasonably measured and allocated to a specific output or work activity. The direct costs are labor and material costs directly associated with product or service, or construction activity are direct costs. Cost of cloth used for making one shirt is direct cost.

DIRECT COSTS
Direct

costs = Direct material cost + direct labor costs + direct expenses

INDIRECT COST
Indirect

costs are that are difficult to attribute or allocate to a specific output or work activity. Example: common tools, general supplies and equipment maintenance in a plant are treated as indirect cost.

OVERHEAD COSTS
It

is plant operating costs that are not direct labor or direct materials costs.

STANDARD COSTS

This costs are represented by costs per unit of output that are established in advance of actual production or service delivery. They are from anticipated direct labor hours, materials, and overhead categories. Some costs are: 01. Estimating future manufacturing costs, 02. Measuring operating performance by comparing actual cost per unit with the standard unit cost.

03. Establishing the value of work in process and finished inventories.

SUNK COSTS
This

is known as past cost of an equipment or asset. Example: Let us assume that an equipment is purchased three years back for RM 100,000.00. If this is considered for replacement then this is not the cost. Then the purchase value of the equipment in the past is known as sunk cost.

OPPURTUNITY COSTS
It

is the cost of the best rejected and is often hidden or implied. Example: Renting un used space and collect the money.

CASH COST Versus BOOK COST

Payment

by cash is called cash

cost. Non cash/book costs- It did not involve cash transaction. It is the depreciation charged for the use of assets such as plant and equipment.

DEPRECIATION
It

is the decrease in value due to physical properties with the passage of time and use. This helps to reduce during the balance sheet preparation. The actual depreciation cant be achieved.

SELLING PRICE

01. Prime cost = direct material cost + direct cost+ direct expenses 02. Factory cost = prime cost + Factory overhead 03. Costs of production = Factory cost+ office and administrative overhead 04. Cost of goods sold = Cost of production +opening book stock closing finished stock 05. Cost of sales = cost of goods sold + selling and distribution overhead 06. Sales = Cost of sales + profit 07. Selling price per unit = Sales / quantity sold

LIFE CYCLE COST

Life cycle cost is the total cost of ownership of machinery and equipments, including its cost of acquisition, operation, maintenance, conversion, and/or decommission. LCC are summations of cost estimates from inception to disposal for both equipment and projects as determined by an analytical study and estimate of total costs experienced in annual time increments during the project life with consideration for the time value of money. The objective of LCC analysis is to choose the most cost effective approach from a series of alternatives (note alternatives is a plural word) to achieve the lowest long-term cost of ownership. LCC is an economic model over the project life span.

LIFE CYCLE COST

Usually the cost of operation, maintenance, and disposal costs exceed all other first costs many times over (supporting costs are often 2-20 times greater than the initial procurement costs). The best balance among cost elements is achieved when the total LCC is minimized (Landers 1996). As with most engineering tools, LCC provides best results when both engineering art and science are merged with good judgment to build a sound business case for action. Businesses must summarize LCC results in net present value (NPV) format considering depreciation, taxes and the time.

PRODUCT LIFE CYCLE

Product life-cycle (PLC) Like human beings, products also have an arc. From birth to death, human beings pass through various stages e.g. birth, growth, maturity, decline and death. A similar life-cycle is seen in the case of products. The product life cycle goes through multiple phases, involves many professional disciplines, and requires many skills, tools and processes. Product life cycle (PLC) has to do with the life of a product in the market with respect to business/commercial costs and sales measures. To say that a product has a life cycle is to assert three things: Products have a limited life, Product sales pass through distinct stages, each posing different challenges, opportunities, and problems to the seller, Products require different marketing, financing, manufacturing, purchasing, and human resource strategies in each life cycle stage.

FOUR STAGES OF PLC

The four main stages of a product's life cycle and the accompanying characteristics are: Stages:

01.

Market introduction stage

i). costs are very high ii). slow sales volumes to start iii). little or no competition iv). demand has to be created v). customers have to be prompted to try the product vi). makes no money at this stage

FOUR STAGES OF PLC

02.Growth

stage: i). costs reduced due to economies of scale ii). sales volume increases significantly iii). profitability begins to rise iv). public awareness increases v). competition begins to increase with a few new players in establishing market

vi). increased competition leads to price

FOUR STAGES OF PLC

03.Maturity

stage:

i). costs are lowered as a result of production volumes increasing and experience curve effects ii). sales volume peaks and market saturation is reached iii). increase in competitors entering the market iv). prices tend to drop due to the proliferation of competing products v). brand differentiation and feature diversification is emphasized to maintain or increase market share vi). Industrial profits go down

FOUR STAGES OF PLC

04.

Saturation and decline stage: i). costs become counter-optimal ii). sales volume decline iii). prices, profitability diminish iv). profit becomes more a challenge of production/distribution efficiency than increased sales

PRODUCT LIFE CYCLE

BREAK EVEN POINT

Break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". A profit or a loss has not been made, although opportunity costs have been "paid", and capital has received the risk-adjusted, expected return. It is shown graphically, at the point where the total revenue and total cost curves meet. In the linear case the break-even point is equal to the fixed costs divided by the contribution margin per unit.

BREAK EVEN POINT

SOME OF THE FORMUALE

i). Total cost = Total variable cost (v) + Fixed cost (FC)

Ii). Profit = Sales (Fixed cost + Variable cost) = s x Q (FC +vQ) Where s is selling price per unit, v is variable cost, FC is fixed cost, Q volume of production. Total sales = s x Q Fixed cos t Break even quantity =

Sellingpriceperunit Variable cos tperunit

SOME OF THE FORMULAE

Break

even quantity =

FC s v

SOME OF THE FORMUALE

FCxs Break even sales = s v

SOME OF THE FORMUALE

Contribution

= Sales variable cost = sv

= (Sales variable cost)/Sales

Profit volume ratio P/V = Contribution /sales

PROBLEM 1

Alpha associate has the following details: i). Fixed cost RM 20,00,000 ii). Variable cost per unit = RM 100.00 Iii). Selling price per unit RM 200.00 Find the following. a). Break even quantity, b). Break even sales- and c). If the production quantity is 60,000, find contribution.

SOLUTION

a). Break even quantity =

FC s v

20,00,000/200-100 = 20,000 units F Cxs b). Break even sales s v = [20,00,000x200]/(200100)] = 40,00,000

SOLUTION
Contribution

= sales variable cost = sxQvxQ = 200X 60,000 100 X 60,000

= RM 60,00,000

PROBLEM 2

Alpha associate has the following details: i). Fixed cost RM 25,00,000 ii). Variable cost per unit = RM 100.00 Iii). Selling price per unit RM 120.00 Find the following. a). Break even quantity, b). Break even sales- and c). If the production quantity is 120,000, find contribution.

PROBLEM 3

A product is cast first and then machined to give it desired size and finish. The yearly output is 10,000.Various yearly costs are as given below. 01.cost of raw material including transportation cost = 14,000 02. Wages to labor = 30,000 03. Wages to technicians = 5,000 04. Expenditures on maintaining sales and advertising at different places = 10,000 05. Expenses on office and administrative staff = 5,000. 06. Cost of tools and fixtures = 1,000 07. Selling price = 15 % on the manufacturing cost Calculate: 01. Prime cost, 02. Manufacturing cost and 03).Selling price if 15 % the profit rate on manufacturing cost.

SOLUTION 3

Prime cost = direct material cost + direct cost+ direct expenses= 30,000+14,000+1,000 = 45,000 Prime cost per product = 45,000/10,000 = 4.5 Factory cost /product = prime cost + Factory overhead = (44,000+1000)/10,000

= 5 unit cost

Selling price =Manufacturing cost + Profit = Manf.cost + indirect cost + profit of 15 % manuf.cost) = 50,000 + 10,000 + 5,000 + 15% 50,000) = 72,500 for 10,000 pieces. Therefore selling price = 72,500 / 13,300 = 7.25 unit cost

PROBLEM 4

A medium scale industry incurs the following cost for one of their products annually. The production volume on an average is 5000 a year. 01. Raw material cost = 25,000 02. Tool cost = 2,000 03. Cost of lubricants, cutting fluids = 1,000 04. Wages to labor = 10,000 05. Office expenses = 6,000 06. Expenses on sale = 6,000 07. Insurance expenses = 2,000 Find: a). Selling price = if 10% is profit on manf. cost b). Direct cost as per cent of total cost c). Indirect expenses as per cent of total cost.

a). Prime cost = Direct labor + Direct material+ other direct expenses = 25,000+2,000+10,000+1,000 = 38,000 unit cost b). Factory overhead = wages to foreman and supervisory staff + Expense on insurance = 20,000+2,000 = 22,000 unit cost c). Establishment cost = Expenses on office staff + Expenses on sales, and distribution agencies = 6,000+4,000 =10,000 unit cost d). Over all production cost or Total production cost = a+b+c = 38,000+ 22,000+10,000 = 70,000 unit cost

SOULTION 4

Production cost per product = 70,000/ 5,000 = 14.00 unit cost i). Price = 10 % of production cost = 14 +10/100 = 15.40 unit cost ii). Direct cost as percentage of total cost = 38,000 / 70,000 = 54.3 % iii). Indirect cost as percentage of total cost = [(22,000+10,000)/70,000 ] 100 = 45.7 %