IEDA 3230: Engineering Economy

Costs and Cost Estimation

Agenda

Motivating examples

Types of cost

Estimation of costs
Motivating example (1)

Consider a bottle of water; price: HK$ 3.60 (@ park-n-shop)

How much does it cost (to produce it)?
 Motivating example (2)

John bought a movie ticket @Cityplaza, for HK$60

Later, his friends told him that he wouldn’t like the movie at all

Cost of travel to (and back from) Cityplaza = HK$20

Q1. If he goes, Total cost = $60 + $20 = $80

If he does not go, is the $60 a waste?

Q2. Is there a difference if he’d bought the $85 ticket @Palace ifc?
Significance of ‘cost’

Profit = Revenue – Cost

Revenue = price * quantity sold

 You can increase profit by

(a) increasing revenue (how?)

(b) reducing cost (how)

cost = fixed cost + variable cost

how to estimate these?

 Definitions
In a productive activity, variable costs account for the costs
that increase with the level of the activity (e.g. the number
of items produced); fixed costs account for those costs that
we must pay irrespective of the level of the activity.

revenue = p*q
L(q): loss
p(q) p(q): profit
Cost, Revenue, $

CT = CF + qcv
CT: total cost
CF: fixed cost
CF cv: variable cost
L(q)
q: demand

q' quantity sold = demand, q

𝑑𝐶𝑇
marginal cost is the change in CT per extra unit of q, =
𝑑𝑞
Example

A retailer (e.g. sandwich shop) orders q bottles of

fresh juice every day from a wholesaler
Each bottle of juice costs $6
The delivery truck company charges $200

fixed cost = cost of delivery = $200

variable cost = cost per bottle = $6 * q

marginal cost:
at q = 1: $206
at normal levels of q: $6
if q > 5000 (needs second truck): ??
Direct and Indirect Costs

direct cost
Cost directly incurred with a specific project

e.g. cost of juice, trucking are direct costs

indirect cost
Other operational costs that are allocated to the project

e.g. salaries of employees, electricity, …

Book costs, Sunk costs and Opportunity Costs

A design company bought 5 computers for $70,000

Each can be used for 5 years
This $70,000 is a cash cost at the time of purchase
It is a sunk cost after the time they are purchased.

Suppose we wish to compute the net worth (= total

assets – total debt) of the company.
What is the value of the computers in this calculation...
… 1 year after date of purchase ?
 $70000 - $14000 (constant yearly depreciation)
[in accounting, this $14000 is called a book cost]
Book costs, Sunk costs and Opportunity Costs..

Suppose we can sell the (old) computers for $20000 and

buy 5 new ones for $50000

In deciding whether or not to upgrade the computers,

sunk cost = $70000
opportunity cost of not replacing computers = $20000
In comparing investment alternatives, if pi is the return
of option i,
opportunity cost of option i = max{pj} - pi
Life Cycle Costs

lifecycle cost is the sum of all costs related to a project

(or product) during its life span

The life cycle starts with the identification of the need

of a project (or product), ends with the retirement of
the project (or product)

Life cycle can be divided into two stages

acquisition phase and operation phase
Life Cycle Costs

Acquisition phase
Needs assessment
Conceptual design, prototype development
Detail design, facility and resource acquisition

Operation phase
Production
Operation and maintenance
Retirement

In most engineering projects, 80% of lifecycle cost is

determined by decisions made in the acquisition phase
Cost of design changes for a project increases rapidly
as time goes on
Life Cycle Costs

Cost
cumulative committed
lifecycle cost
potential for lifecycle
cost savings
cumulative lifecycle
costs

Time
assess needs concept detailed production operation/ retirement;
define reqts. design; design; use disposal
prototype acquire
resource

acquisition operation

[source: Fig. 2-1, Sullivan, Wicks, Koelling, Engineering Economy

 Relation of costs with profit

profit = revenue – total cost

p
p = p q – CT

For many commodities, q = f(p)

q
f(p) is typically a decreasing function

A linear approximation: p = a – bq
Relation of costs with profit..

Assuming linear demand function,

p = p q – CT
= (a – bq)q – (CF + q cv)
= aq – bq2 - CF - q cv

Setting dp/dq = a – 2bq - cv = 0  q* = (a - cv)/2b

max profit Total revenue

CT = CF + qcv
Cost, Revenue, $

when is p(q) < 0

CF

𝑞1′ q* 𝑞2′
Cost-driven design

Cost reduction is important in profit maximization

Profit = Revenue - Cost

How?
Identify the design parameter(s) that affect cost
Model: the relationship between cost, design parameter(s)
Solve: find the value of the design parameter(s) that
minimize the cost
Verify: apply result to (new) design and test
Cost-driven design (example)

Airline flight speeds and costs

Northwest airlines:
Paris – Minneapolis, 8 minutes slower
Saving 162 gallons of fuel

Jetblue:
Average two minutes slower for each flight
Total saving: ~ USD 13.6 million each year

Southwest airlines:
Slower by 1~3 minutes for each flight
Saving: ~ USD 42 million each year

Maritime industry is doing the same thing

Cost-driven design (example)..

The cost, C0, of operating an airplane mainly depends on

the velocity (v) and the trip length (n).

In certain range, C0 = knv3/2

To minimize the operating cost, what is the design

variable we can control?

Cost of passenger time has to be considered

Estimated as $300,000 per hour

What is the tradeoff?

Operating cost vs. passenger cost
Cost-driven design (example)...

Total cost = C0 + Cc = knv3/2 + 300000 n/v

How to know k?

Information for obtaining k

the operating cost is $300 per mile at a speed of 400 mph
 300 = k (400)3/2
 k = $0.0375
Cost-driven design (example)...

Total cost = CT = C0 + Cc = 0.0375 nv3/2 + 300000 n/v

dCT 3 1/ 2 300000n
Setting  0.0375( )nv  2
0
dv 2 v

v 5 / 2  300000 / 0.05625  5333333

v*  490.68 miles per hour

Verify that v* minimizes CT

Make or Buy decisions: motivating examples

Pre-2005, CPU chip used in all Apple computers was PowerPC

- designed by Apple (collaboration with IBM, Motorola)

After 2005, Apple outsources CPU design/fabrication to Intel x86 chips.

Samsung electronics is one of the largest semiconductor fabricators in the

world

Samsung produces smartphones (competes with Sony electronics)

Samsung phones use Sony sensors in their cameras (e.g. Sony IMX333 and
S5K2L2 ISOCELL in Samsung Galaxy S8, S8+ phones).

Long-term make-or-buy decisions involve complex considerations;

We will look at a simplification (short-term)
Make or Buy: example

Manufacturing shop with an area of 100 m2

Produces 576 pieces of X per day, (+ other products)
Costs Total
Direct labor Operator 1 4 hrs/day 22.5/hr 90
Foreman 1 Part time 30/day 30
Sub-total 120
Direct materials 86.4
Overhead Power, Space 100 m2 0.82/m2 82
Total: $288

Foreman found possibility to buy externally at

0.35/piece  estimated cost = 0.35*576 = $201.6
Make or buy: example..

Cost to make: $288

Cost to buy: $201.6

However, actual savings if 'buy':

Direct labor:
$90 saved on operator -- can be re-assigned
$0 saved on foreman -- supervising other operations
Materials:
$86.4
Overhead:
$3 on power; $0 on space

Total savings if 'buy': $(90 + 86.4 + 3) = $179.4

 Total cost if 'buy' = 201.6 + (288 – 179.4) = 310.2 > cost if 'make'
Summary

- Basic types of cost, some simple deterministic examples

Acknowledgements:
1. Lecture notes (IELM 3230), Prof Xiangtong Qi
2. Chapters 2, 3: Engineering Economy by Sullivan, Wicks, Koelling

Next: Data driven cost estimation, regression