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Costs and Cash Flows

EGG 307
Summer Session I

May 2016

Engineering Economic
Analysis - Seven Steps
1.
2.
3.
4.

5.
6.
7.

Recognize and formulate the problem.


Develop feasible alternatives.
Develop cash flows for each alternative.
Select a criterion (or criteria) for
determining the preferred alternative.
Analyze and compare alternatives.
Select the preferred alternative.
Perform monitoring and post-evaluation.
2

Cash Flows

A cash flow is a receipt or


payment of an amount of
money defined by 1) its
dollar value and 2) the
time of its occurrence
Cash flow diagrams
represent costs and
revenues over time.
CostandRevenueestimation
forthefuturealwaysinvolve
uncertainty.

$ value

time

Top-Down Estimate

The first step in the determination of the


cash flows is the estimation of costs and
revenues.
The top-down approach takes data from
similar projects and modifies them to
reflect the current project.

Estimate your cost of a college degree: use the


cost of your brothers degree three years ago
and adjust it for inflation. Add $5000 for the
cost of your participation in extra curricular
activities (your brother was a bookworm)
4

Bottom-Up Estimates

The bottom-up approach is more


detailed, breaking down the project
in small manageable units and
estimating the cost of the parts first.

Bottom-Up: Break down anticipated


expenses in categories: tuition and
fees, books and supplies, living
expenses, transportation and estimate
each as accurately as possible.
5

Cost Terminology

Variable costs change with the level of output


Fixed costs do not change with the level output

Cost

Variable Cost = vx

f
Total Cost = Fixed +Variable
C = f + vx for x > 0

Fixed
Cost

Production
Level (x)

Cost Terminology (contd)

Recurring/Nonrecurring Costs: If costs occur every time


the organization produces goods or services, they are
called recurring. Variable costs are recurring.
Direct/Indirect Costs: If costs can be reasonably
measured and allocated to specific output, they are
called direct.
Overhead Costs: all costs of providing goods and
services other than direct labor and direct material.
Cash/Book Cost: Cost that involves a payment of cash is
called a cash cost. Costs reflected in the accounting
system only are called book costs.

Opportunity Costs

Opportunity Cost: Cost of forgoing


the chance to earn interest (or
profit) on investment funds.
Example:

Your grandmother owns her home,


but lives with your parents. She rents
her $185,000-house for $400/month.
Good idea or lost opportunity?
8

Sunk Costs

Sunk Costs: Past costs that are


unrecoverable are not relevant for
decision-making purposes.
Example:

You are shopping for a new car, and, that


afternoon, find one you really like for $1000.
You leave a $100 deposit and plan to return
the next day. That evening, your friend offers
to sell you her car for $850. What to do
think?
9

Life Cycle Costs


Life Cycle Cost

Percent
100
75

Potential for LCC


Savings

Cumulative
Committed LCC
Cumulative LCC

50
25
0

Definition of
Requirements

Conceptual
design

Aquisition Phase

Detailed
design
Production
Planning
Facility Aquisition

Production or
construction

Operation or Retirement and


customer use,
disposal
maintenance
support

Time

Operation Phase

10

Present Economy Studies

When the influence of time on money is


not a significant consideration, analyses
are referred to as present economy
studies

Time horizon is one year or less


No opportunity for earning interest or profit

The criterion for selection is usually

Select the alternative that maximizes profit


Select the alternative that minimizes cost
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Material Selection
Example

After machining, the finished volume of a certain metal


part is 0.17 inch3
Which raw material to choose?

Brass

Aluminum

Machining time/piece (min)

0.64

0.42

Cost of material ($/lb)

0.96

0.52

Scrap value ($/lb)

0.24

none

Cost of operator ($/hr)

12.00

12.00

Density of material (lb/in3)

0.31

0.1

Volume of raw material (in3)

0.3

0.45
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Labor and Material Costs

Labor cost per piece = (time per piece)(labor cost per


time)
Brass: (0.64 min/piece)($12/hr)(1hr/60 min) =
$0.128/pc
Aluminum: (0.42 min/piece)($12/hr)(1hr/60 min)
= $0.084/pc
Material cost per piece =
(volume of raw)(lb per volume)(cost per lb)(leftover vol. of raw)(lb per vol.)(scrap value per lb)
Brass: (0.3 in3)(0.31 lb/in3)($0.96/lb) (0.13 in3)(0.31 lb/in3)($0.24/lb) =$0.080/pc
Aluminum : (0.45 in 3)(0.10 lb/in 3)($0.52/lb) =$0.023/pc
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Total Cost

Brass: $0.128/pc + 0.080/pc =


0.208/pc
Aluminum: $0.084/pc + 0.08023/pc =
0.107/pc

Choose aluminum to minimize


total cost
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Make vs. Buy Example

A company, not operating at full capacity, is


considering making a part currently bought.
Make

Direct Material

$1.50

Direct Labor

$1.35

Overhead - variable

$0.90

Overhead - fixed

$4.25

Total Unit Cost

$8.00

Buy

$7.50
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Analysis

Utilizing the excess capacity has no


opportunity costs since the plant cannot
invest unused capacity as easily as it can
invest unused cash.
Therefore, this product will not change
fixed overhead for the plant.
So the real cost per unit is: $1.50 + $1.35
+ $0.90 = $3.75
Therefore, it is better to make the product
in-house.
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