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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
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)

## 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 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

customer use,
disposal
maintenance
support

Time

Operation Phase

10

## 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

## Select the alternative that maximizes profit

Select the alternative that minimizes cost
14

Material Selection
Example

## After machining, the finished volume of a certain metal

part is 0.17 inch3
Which raw material to choose?

Brass

Aluminum

0.64

0.42

0.96

0.52

0.24

none

12.00

12.00

0.31

0.1

0.3

0.45
15

## 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
16

Total Cost

## Brass: \$0.128/pc + 0.080/pc =

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

total cost
17

## A company, not operating at full capacity, is

considering making a part currently bought.
Make

Direct Material

\$1.50

Direct Labor

\$1.35

\$0.90

\$4.25

\$8.00

\$7.50
18

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