ENGINEERING ECONOMIC

CONCEPTS OF COST, REVENUE

AND PROFIT

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 LEARNING OUTCOME
• COSTING APPROACHES AND TYPE OF COSTS

• THE LAW OF SUPPLY AND DEMAND

• TYPES OF REVENUES

• PRODUCERS EQUILIBRIUM

• BREAK EVEN POINT

• PROFIT MAXIMIZATION © 2012 by McGraw-Hill, New York, N.Y All Rights Reserved
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 WHAT IS COST
• An amount that has to be paid or given up in order to get
something.

• In business, cost is usually a monetary valuation of (1) effort, (2)

material, (3) resources, (4) time and utilities consumed, (5) risks
incurred, and (6) opportunity forgone in production and delivery
of a good or service.

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 1.0 COST ESTIMATING
Used to describe the process by which the present and future cost
consequences of engineering designs are forecast.

• Provide information used in setting a selling price for quoting, bidding, or

evaluating contracts
• Determine whether a proposed product can be made and distributed at
a profit (EG: price = cost + profit)
• Evaluate how much capital can be justified for process
changes or other improvements
• Establish benchmarks for productivity improvement programs
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 2.0 COST ESTIMATING APPROACH

• Top Down

• Bottom Up

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 2.1 TOP-DOWN APPROACH
• Uses historical data from similar engineering projects
• Used to estimate costs, revenues, and other parameters for
current project
• Modifies original data for changes in inflation / deflation,
activity level, weight, energy consumption, size, etc…
• Best use is early in estimating process
 2.2 BOTTOM-UP APPROACH
• More detailed cost-estimating method
• Attempts to break down project into small, manageable units
and estimate costs, etc….
• Smaller unit costs added together with other types of costs to
obtain overall cost estimate
• Works best when detail concerning desired output defined and
clarified
 3.0 TYPE OF COST
Capital Costs
• Fixed Capital (Equipment / Building)
• Working Capital (the funds required for current assets
needed for start-up and subsequent support of operation activities.

Operating Costs (incurred due to volume of production)

• Direct costs (Materials, labour, utilities, supplies, waste treatment, etc.)
• Indirect costs or Overhead (common tools, electricity)
• Fixed costs (Land taxes, insurance, plant administration).
• General costs (Corporation, sales & marketing, R&D)
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Direct costs can be reasonably measured and allocated to a specific
output or work activity -- labour and material directly allocated with a
product, service or construction activity;

Indirect costs are difficult to allocate to a specific output or activity --

costs of common tools, general supplies, and equipment maintenance ;

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The selling price of a product is derived as shown below:

(a) Direct material costs + Direct labour costs = Prime cost

(b) Prime cost + Factory overhead = Factory cost
(c) Factory cost + Office and administrative overhead = Costs of
production
(d) Cost of production + Opening finished stock – Closing finished stock
= Cost of goods sold
(e) Cost of goods sold + Selling and distribution overhead = Cost of sales
(f) Cost of sales + Profit = Sales
(g) Sales/Quantity sold = Selling price per unit

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 3.1 OTHER COSTS / REVENUES
• Marginal cost
Cost of producing an additional unit of that product. Say the cost of producing
20 units of a product be RM 1000, and the cost of producing 21 units of the
same product be RM 1005. Then the marginal cost of producing the 21st unit is
RM 5.

• Marginal revenue
Marginal revenue of a product is the incremental revenue of selling an
additional unit of that product. Let, the revenue of selling 20 units of a product
be RM 15,000 and the revenue of selling 21 units of the same product be RM
15,085. Then, the marginal revenue of selling the 21st unit is RM 85.
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• Sunk cost
The past cost of an equipment/asset. Let us assume that an equipment has been
purchased for RM 100,000 about three years back. If it is considered for
replacement, then its present value is not RM 100,000. Instead, its present
market value should be taken as the present value of the equipment for further
analysis. So, the purchase value of the equipment in the past is known as its
sunk cost.

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• Opportunity cost
In practice, if an alternative (X) is selected from a set of competing alternatives
(X,Y), then the corresponding investment in the selected alternative is not
available for any other purpose. If the same money is invested in some other
alternative (Y), it may fetch some return. Since the money is invested in the
selected alternative (X), one has to forego the return from the other alternative
(Y). The amount that is foregone by not investing in the other alternative (Y) is
known as the opportunity cost of the selected alternative (X). So the
opportunity cost of an alternative is the return that will be foregone by not
investing the same money in another alternative.

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 Opportunity Cost
 Definition: Largest rate of return of all projects not
accepted (forgone) due to a lack of capital funds
 If no MARR is set, the ROR of the first project not undertaken
establishes the opportunity cost

Example: Assume MARR = 10%. Project A, not

funded due to lack of funds, is projected to
have RORA = 13%. Project B has RORB = 15%
and is funded because it costs less than A
Opportunity cost is 13%, i.e., the opportunity to
make an additional 13% is forgone by not
funding project A
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 3.2 LIFE-CYCLE COST
• Sum of all recurring and one-time (non-recurring) costs over the full
life span or a specified period of a good, service, structure, or
system. It includes purchase price, installation cost, operating costs,
maintenance and upgrade costs, and remaining (residual or salvage)
value at the end of ownership or its useful life.

• A life-cycle cost analysis is a methodology that allows us to analyse

multiple alternatives with different initial costs, yearly maintenance
requirements, and expected service lives to compare their initial
costs to the total costs of ownership (COO).
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3.3 FIXED, VARIABLE, AND INCREMENTAL
COSTS
Fixed costs are those unaffected by changes in activity level over a feasible
range of operations for the capacity or capability available.

Typical fixed costs include insurance and taxes on facilities, general

management and administrative salaries, license fees, and interest costs on
borrowed capital.

When large changes in usage of resources occur, or when plant expansion or

shutdown is involved, fixed costs will be affected.
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Variable costs are those associated with an operation that vary in total
with the quantity of output or other measures of activity level.

Example of variable costs include : costs of material and labour used in a

product or service, because they vary in total with the number of output
units -- even though costs per unit remain the same.

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Incremental cost is the additional cost that results from increasing the
output of a system by one (or more) units.
Incremental cost is often associated with “go / no go” decisions that
involve a limited change in output or activity level.

EXAMPLE
the incremental cost of driving an automobile might be $0.27 / mile.
This cost depends on:
mileage driven;
mileage expected to drive;
age of car;
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3.4 RECURRING AND NONRECURRING
COSTS
Recurring costs are repetitive and occur when a firm produces similar
goods and services on a continuing basis.

Variable costs are recurring costs because they repeat with each unit of
output .

A fixed cost that is paid on a repeatable basis is also a recurring cost:

Office space rental

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Nonrecurring costs are those that are not repetitive, even though the
total expenditure may be cumulative over a relatively short period of
time;

Typically involve developing or establishing a capability or capacity to

operate;

Examples are purchase cost for real estate upon which a plant will be
built, and the construction costs of the plant itself;

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Representative costs per unit of output that are established in advance of
actual production and service delivery;

Standard Cost Element Sources of Data

Direct labor Standard labor rate,

+
Direct material Material quantities per unit, standard unit
+ cost

Factory Overhead Total factory overhead costs allocated

based on prime costs;
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4.0 LAW OF SUPPLY AND DEMAND
Law of Demand (Consumer)

Demand – Different quantities that people are willing and able to buy at
different prices.

P Qd

P Qd

Inverse relationship between price and quantity demanded

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P

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P

P2
WHY ???
P1

Q
Q2 Q1
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1. Substitution effect

2. Lesser purchasing power

3. Law of Diminishing marginal utility-Carl Menger (1840–1921)-

as a person increases consumption of a product - while keeping
consumption of other products constant - there is a decline in the
marginal utility (satisfaction or happiness) that person derives from
consuming each additional unit of that product.

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Law of Supply (Producer)

Supply – Different quantities that firms are willing and able to produce at
different prices.

P Qs

P Qs

Direct relationship between price and quantity supplied

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 S

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5.0 TOTAL REVENUE, AVERAGE
REVENUE AND MARGINAL REVENUE
What is Revenue ?

Why people engaged in economic activities?

Revenue – payment in terms of money which is received from sale of

product or services

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Economic activities involve
money RM50= revenue to the seller

Buyer Seller
bag

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 Total Revenue

Revenue Average Revenue

Marginal Revenue

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No of bags sold Price of bag (RM) Total Revenue
(RM)
1 20 20
1 30 50
1 40 90
1 50 140
1 60 200

Total revenue (TR) – Total money received

from sale of all product

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No of bags sold Price of bag (RM) Total Revenue
(RM)
1 20 20
1 30 50
1 5 40 90
1 50 140
1 60 200

Average revenue (AR) = TR / No of units sold

= 200 / 5 = 40

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No of bags sold Price of bag (RM) Total Revenue
(RM)
1 20 20
Net addition to TR
1 30 50
= 50 - 20
1 40 90
1 50 140
1 60 200

Marginal revenue (MR) = Net addition to TR when one additional

unit is sold.
MR = Change in TR / change in quantity sold

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 5.1 RELATIONSHIP BETWEEN TOTAL
REVENUE AND MARGINAL REVENUE
TR MR
Bag sold Total bag Price of Marginal Total +
sold bag revenue revenue
Maximum 0
1 1 20 20 20
1 2 25 25 45 -
1 3 30 30 75
1 4 15 15 90
MR still positive
1 5 0 0 90 MR = 0
1 6 -10 -10 80
MR = -ve

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 TR MR
Bag sold Total bag Price of Marginal Total +
sold bag revenue revenue
Maximum 0
1 1 20 20 20
1 2 25 25 45 -
1 3 30 30 75
1 4 15 15 90
MR still positive
1 5 0 0 90 MR = 0
1 6 -10 -10 80
MR = -ve

Cost > selling price

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 6.0 PRODUCER’S EQUILIBRIUM

Supply and Demand

Producer / manufacture produce goods or services sells

Manufacture goods costs revenue

Revenue – Costs = Profit

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 Revenue
RM110 (profit)

Producer Cost to produce product

RM100
RM90 (loss)

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Producers produce goods not for charity, but to make profit as
much as possible.

Producers Equilibrium

The point at which the profits earned are maximum

Quantity of goods or level of production

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Unit of output Total revenue Total cost profits

10 200 210 -10

20 240 245 -5

30 280 280 0

40 320 315 5

50 360 340 20

60 400 390 10

70 440 435 5

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Unit of output Total revenue Total cost profits

10 200 210 -10

20 240 245 -5

30 280 280 0

40 320 315 5

50 360 340 20 Maximum profit

60 400 390 10

70 440 435 5

At 50 units of production level, the producers achieved equilibrium

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 7.0 BREAK EVEN POINT

Break even point is the point when the total revenue earned by
a producer is equal to the total cost incurred by him.

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 Revenue
RM110 (profit)

Producer Cost to produce product Break even

RM100
RM90 (loss)

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Unit of output Total revenue Total cost profits

10 200 210 -10

20 240 245 -5

30 280 280 0
Unit of output Total revenue Total cost profits
40 320 315 5
10 200 210 -10
50 360 340 20
20 240 245 -5
60 400 390 10
30 280 280 0
70 440 435 5
40 320 315 5

50 360 340 20

60 400 390 10

70 440 435 5

TR = TC (break even)
Profit = TR – TC = TR-TR =0
Break even occurs at 30 units of output
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8.0 PROFIT MAXIMIZATION

Profit = Total Revenue – Total Cost

Max Profit = Maximum Total Revenue – Minimum Total Cost

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TR = P x Q

P (RM) Q (unit) TR (RM)

5 0 0
5 1 5
5 2 10
5 3 15

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Total Revenue = P x Q

RM earned

TR

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WHAT ABOUT PROFIT ???

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COMBINED EFFECT OF
TR AND TC

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RM earned

TC TR

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 TC TR
RM earned

Q
Q1 Q2
RM earned
At Q1 and Q2, TR = TC;
(+) Profit = 0

(0)
Q1 Q2
Q
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 TC TR
RM earned

TC>TR
(loss)

Q
Q1 Q2
RM earned
From 0 – Q1
(+)

(0)
Q1 Q2
Q
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 TC TC>TR TR
RM earned
(loss)

TC>TR
(loss)

Q
Q1 Q2
RM earned
From Q2 and above
(+)

(0)
Q1 Q2
Q
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 TC TC>TR TR
RM earned
(loss)

TC< TR
(Profit)
TC>TR
(loss)

Q
Q1 Q2
RM earned
Between Q1 and Q2
(+)

(0)
Q1 Q2
Q
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Now, what is the level of output that you will pick for you
business ??

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RM earned max π
(+)

(0) Q
Q*
(-)
π

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RM earned Slope = 0

(+)

(0) Q
Q*
(-)
π

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RM earned
(+)

(0) Q
Q*
(-)
π

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FOR MAXIMUM PROFIT (π)

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