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By Amrit Nakarmi EEP-Lecture #5 MSREE

03 July 2011


Need of cost estimation

At the level of plant operations, engineers must make decisions involving materials, plant facilities, and the in-house capabilities of the company personnel. All these operational activities require the costs associated with various production and manufacturing activities. It is important to understand how various costs respond to changes in levels of business activities.


General Cost Terms

We shall be focusing on costs and their behavior

related to manufacturing because its basic activities such as purchasing raw materials, producing finished products, marketing are commonly found in most of the other businesses.


Manufacturing Costs
Manufacturing converts raw materials into finished

goods and it incurs various costs of operating a factory or plants.


Manufacturing Costs
Manufacturing Costs

Direct material costs are costs of materials used in the final product and they can be easily traced into it.
Direct Material Costs

Direct labor costs are costs of labor that go into the production of a product.
Direct Labor Costs

Manufacturing overheads

Manufacturing overhead costs are costs that are included except material and labor costs.
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Non-manufacturing Overheads
There are other costs that are included in the cost of the product but are not manufacturing costs.
Non-manufacturing overhead (administrative)

heat and light, salary of non-manufacturing staff, stationery, insurance, depreciation, etc. Marketing & selling costs advertising, shipping, sales commission, salary of salesmen etc.


Cost Classification for Financial Statements

As per matching principle, the costs incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.
Some costs are matched against periods and become expenses immediately. Other costs, however, are matched against products and don not become expenses until the products are sold.


Cost Classification for Financial Statements

Period Costs costs that are charged as expenses if they are incurred in the same period. Example: administrative expenses, income tax, VAT, selling expenses etc.
Product Costs costs that are related to the products than periods. These costs are direct material costs, direct labor costs, and manufacturing overheads. Product costs are sometimes are also called inventory costs.
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Income Statement Revenue Costs of Goods Sold (COGS) Gross Profit Expenses Net Income Balance Sheet
Product Costs
When goods are sold

Period Costs

Current Assets Inventory


Classification of operating costs (in a unit price of an Ice cream)

Ice cream (cream, sugar, milk, and milk solids) Cone Rent Wages Payroll taxes Sales taxes Business taxes Debt service Supplies Utilities (water, electricity) Other (insurance, advertising, fees etc) Profit Price of a unit cone of ice cream

$0.65 0.05 0.61 0.25 0.25 0.23 0.08 0.23 0.09 0.08 0.05 0.13 $2.50

Product Costs & Period Costs

Product costs (costs incurred in preparing 185,000 cones/year
Raw materials: Ice cream @ $0.65 $120,250 Cone @$0.05 9,250 Labor: Wages @0.25 46,250 Overhead: Supplies @ $0.09 16,650 Utilities @ $0.08 14,850 Total Product Cost $207,000 All other are period costs incurred in running the shop regardless of the sales volume.



Cost Behavior
An engineer needs to know what will happen if the production is increased by 5% and what will be the product cost? Cost behavior describes how a cost item will react or respond to changes in the level of business activity. Volume index the unit or measure used to define a volume is called volume index such as pieces produced or KWh electricity produced or used.



Cost Behavior
Fixed costs these costs do not change within a given time frame under a relevant range. (example ; rent, insurance, administrative expenses, depreciation etc.) Variable costs costs vary as per the volume of production. (example: direct material costs, direct labor costs, direct manufacturing costs etc.) Mixed costs these costs contain both the fixed and variable costs such as depreciation and utilities.



Average Unit Cost

We often use the term average cost to express activity cost on a per unit basis.
The variable cost per unit volume is constant. Fixed cost per unit volume varies with change in volume:

as volume increases, the fixed cost per unit decreases. The mixed cost per unit also changes as volume changes, but the amount of change is smaller than that for fixed costs.



Cost Volume Diagram

Amount Fixed costs

Variable costs





Cost Volume Diagram

Amount Total costs = fixed costs + variable costs

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Break-Even Volume Analysis

Sandstone Corp. has one of its manufacturing plants operating on a single shift 5-day week. The plant is operating at its full capacity (24,000 units of output per week) without the use of overtime or extra-shift operation. Fixed costs for single shift operation amount to $90,000 per week. The average variable costs is a constant $30 per unit, at all output rates upto 24,000 units per week. The company has received an order to produce extra 4,000 units per week beyond the current single shift maximum capacity.



Break-Even Volume Analysis

Two options are being considered to fill the new order.
Option 1: Increase the plants output to 36,000 units a week by

adding overtime or by adding Saturday operation or both. No increase in fixed costs is entailed, but the variable cost is $36 per unit for output in excess of 24,000 units per week upto 36,000 unit capacity. Option 2: Operate a second shift. The maximum capacity of the second shift is 21,000 units per week. The variable cost on the second shift is $31.50 per unit and operation of a second shift entails additional fixed costs of $13,500 per week.

Determine the range of operating volume that will make option 2 profitable.



Break-Even Volume Analysis

Option 1: Overtime and Saturday operation: $36Q Option 2: Second shift operation: $13,500 + $31.50 Q Then the breakeven volume Q: 36Q = 13,500 + 31.5 Q Q =3,000 units.



Break-Even Volume Analysis

Increased Operating cost
Relevant prod range for Option 1 Relevant production rage for Option 2

36 Q Cost $108,000

13,500 +31.5 Q

Q =3,000 units

21,000 units Volume



12,000 units

Make or Buy Decision

Consider Benson Co., a farm equipment manufacturer that currently produces 20,000 units of gas filters annually for use in its lawnmower production. The expected annual production cost of the gas filters is summarized as follows:



Make or Buy Decision

Variable costs: Direct materials $ 100,000 Direct Labor 190,000 Power & water 35,000 Fixed costs: Heating & light 20,000 Depreciation 100,000 Total cost $445,000 Tompkins Co. has offered to sell Benson 20,000 units of gas filters for $17.00 per unit. If Benson accepts the offer, some of the manufacturing facilities currently used to manufacture the gas filters could be rented to a third party at an annual rent of $35,000. Should Benson accept Tompkins offer, and why?



Make or Buy Decision (solution)

Make Opt Buy Opt Differential cost Variable costs Direct materials Direct labor Power & water Gas filters Fixed costs Heating light Depreciation Rental income Total costs Unit cost

$100,000 190,000 35,000 340,000 20,000 100,000 $445,000 $22.50 20,000 100,000 -35,000 $425,000 $21.50

-100,000 -190,000 -35,000 340,000

-35,000 -$20,000 -$1.00


Report on Financial Ratio Analysis

Executive Summary Company Background Objective Methodology Findings Conclusion
Text body should contain 15 to 20 pages, laser printed with annex. The report should contain graphs of analysis and their explanation.The text lines should be 1.4 space and of 12 points. References should be given as done in the journal articles.
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Chapter 2 Page 56

2.1, 2.2, 2.3, 2.5, & 2.6

Chapter 3 Page 89

3.1 to 3.6, 3.8, 3.10, 3.11, & 3.12