Cost Concepts

and Design
Economics

23
 COST TERMINOLOGIES

❖Fixed costs are those unaffected by changes in activity level over a

feasible range of operations for the capacity or capability available.
Include insurance and taxes on facilities, general management and
administrative salaries, license fees, and interest costs on borrowed
capital.

24
 COST TERMINOLOGIES

❖Variable costs are those associated with an operation that varies in

total with the quantity of output or other measures of activity level. For
example, the costs of material and labor used in a product or service
are variable costs

25
COST TERMINOLOGIES

26
 COST TERMINOLOGIES

❖Incremental cost (or incremental revenue) is the additional cost (or

revenue) that results from increasing the output of a system by one
(or more) units.
❖Often associated with “go–no go” decisions

27
 COST TERMINOLOGIES

❖A marginal cost is the variable cost for one more unit

❖ Average cost is the total cost divided by the number of units.

28
 COST TERMINOLOGIES

❖ Direct costs are costs that can be reasonably measured and allocated to a
specific output or work activity. Can be fixed or variable.

❖ Indirect costs are costs that are difficult to allocate to a specific output or work
activity. Can be fixed or variable.

❖ Standard costs are planned costs per unit of output that are established in
advance of actual production or service delivery

29
 COST TERMINOLOGIES

❖ Cash cost is the cost that involves payment of cash and results in a cash flow.

❖ Book cost (noncash cost) is the cost that does not involve a cash transaction and
is reflected in the accounting system.

30
 COST TERMINOLOGIES

❖ A sunk cost is one that has occurred in the past and has no relevance to
estimates of future costs and revenues related to an alternative course of action.

31
 COST TERMINOLOGIES

❖ An opportunity cost is incurred because of the use of limited resources, such that
the opportunity to use those resources to monetary advantage in an alternative
use is foregone.

“An opportunity cost is the benefit that is forgone by engaging a business resource in a chosen
activity instead of engaging that same resource in the forgone activity.”

32
 COST TERMINOLOGIES

❖ Life-cycle cost refers to a summation of all the

costs related to a product, structure, system, or
service during its life span.

❖ Begins with identification of the economic need or

want (the requirement) and ends with retirement
and disposal activities.

Life-cycle costing refers to the concept of designing products, goods, and services with a full and
explicit recognition of the associated costs over the various phases of their life cycles.

33
 COST TERMINOLOGIES

❖ Investment cost is the capital required for most of the activities in the acquisition
phase.

❖ Operation and maintenance cost (O&M) includes many of the recurring annual
expense items associated with the operation phase of the life cycle.

❖ Disposal cost includes those nonrecurring costs of shutting down the operation and
the retirement and disposal of assets at the end of the life cycle.

34
 COST TERMINOLOGIES

❖ Recurring costs refer to any expense that is known and anticipated, and that occurs
at regular intervals.

❖ Nonrecurring costs are one-of-a-kind expenses that occur at irregular intervals and
thus are sometimes difficult to plan for or anticipate from a budgeting perspective.

35
 SAMPLE EXERCISE

In connection with surfacing a new highway, a contractor has a choice of two sites on which to set
up the asphalt-mixing plant equipment. The contractor estimates that it will cost $2.75 per cubic yard
mile (yd3-mile) to haul the asphalt-paving material from the mixing plant to the job location. Factors
relating to the two mixing sites are as follows (production costs at each site are the same):

The job requires 50,000 cubic yards of mixed-

asphalt-paving material. It is estimated that four
months (17 weeks of five working days per
week) will be required for the job

Assume that the cost of the return trip is negligible. Which is the better site? For the selected site, how
many cubic yards of paving material does the contractor have to deliver before starting to make a profit
if paid $12 per cubic yard delivered to the job location?
36
 SAMPLE EXERCISE
4 months will be required
50,000 cubic yards
$12 per cubic yard to be paid for the
chosen site

SITE A SITE B
COSTS FIXED COSTS VARIABLE COSTS FIXED COSTS VARIABLE COSTS

Rent $2,000 X 4 = $8,000 $7,000 X 4 = $28,000

Setup/removal $15,000 $50,000

Flagperson 5X17X$150 = $12,750

Hauling 4x50,000x$2.75 = 3x50,000x$2.75 =

$550,000 $412,000
TOTAL COSTS $573,000 $503,250
37
 SAMPLE EXERCISE
4 months will be required
50,000 cubic yards
$12 per cubic yard to be paid for the chosen site

𝑇𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑣𝑎𝑟𝑖𝑏𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠 = 𝑇𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒
$2.75 3
3 𝑚𝑖𝑙𝑒𝑠 = $8.25 𝑖𝑛 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑦𝑎𝑟𝑑 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑒𝑑
𝑦𝑎𝑟𝑑 3 − 𝑚𝑖𝑙𝑒

𝐿𝑒𝑡 𝑥 𝑏𝑒 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑦𝑎𝑟𝑑 3 delivered to start gaining profit

($28,000 + $50,000 + $12,750) + $8.25𝑥 = $12𝑥

$90, 750 + $ 8.25𝑥 = $12𝑥
𝒙 = 𝟐𝟒, 𝟐𝟎𝟎 𝒚𝒂𝒓𝒅𝟑 𝐝𝐞𝐥𝐢𝐯𝐞𝐫𝐞𝐝
𝑇ℎ𝑒𝑟𝑒𝑓𝑜𝑟𝑒, 𝑏𝑦 𝑢𝑠𝑖𝑛𝑔 𝑆𝑖𝑡𝑒 𝐵, 𝑡ℎ𝑒 𝑐𝑜𝑛𝑡𝑟𝑎𝑐𝑡𝑜𝑟 𝑤𝑖𝑙𝑙 𝑏𝑒𝑔𝑖𝑛 𝑡𝑜 𝑚𝑎𝑘𝑒 𝑎 𝑝𝑟𝑜𝑓𝑖𝑡
𝑜𝑛 𝑡ℎ𝑒 𝑗𝑜𝑏 𝑎𝑓𝑡𝑒𝑟 𝑑𝑒𝑙𝑖𝑣𝑒𝑟𝑖𝑛𝑔 24,200 𝑐𝑢𝑏𝑖𝑐 𝑦𝑎𝑟𝑑𝑠 𝑜𝑓 𝑚𝑎𝑡𝑒𝑟𝑖𝑎𝑙. 38
 COST
ESTIMATION
• E S T I M AT E S T H AT M AY B E N E E D E D I N
E N G I N E E R I N G E C O N O M I C A N A LY S I S
INCLUDE PURCHASE COSTS, ANNUAL
R E V E N U E , Y E A R LY M A I N T E N A N C E ,
I N T E R E S T R AT E S F O R I N V E S T M E N T S
ANNUAL LABOR AND INSUR ANCE COSTS,
E Q U I P M E N T S A LV A G E V A L U E S , A N D TA X
R AT E S .

• D I F F I C U LT I E S : O N E - O F - A - K I N D
E S T I M AT E S , T I M E A N D E F F O R T
A V A I L A B L E , E S T I M AT O R E X P E R T I S E
39
TYPES
OF • The intent is to quantify and
ESTIMATES consider the order of
magnitude of the numbers
involved.
• These estimates require
minimum resources to
develop,

Rough • And their accuracy is

generally −30 to +60%.
estimates

40
TYPES
OF • Used for budgeting
ESTIMATES purposes at a project’s
conceptual or preliminary
design stages.
• Their accuracy is generally
−15 to +20%.

Semi-detailed
estimates

41
TYPES
OF • These estimates are made
ESTIMATES from detailed quantitative
models, blueprints, product
specification sheets, and
vendor quotes.
• Detailed estimates involve
the most time and resources
to develop and thus are much
Detailed more accurate than rough or

estimates semi-detailed estimates

• Accuracy of these
estimates is generally −3 to
+5%.

42
TYPES
OF • Increased accuracy
ESTIMATES requires added time and
resources.

• There will be some error

even if ample resources and
sophisticated methods are
used.

Increased accuracy
in estimation is a
trade-off with cost!
43
ESTIMATING
MODELS

44
PER UNIT MODEL

❖ The per-unit model uses a “per unit” factor to

develop the estimate desired.
❖ Developing estimates of the rough or order-of-
magnitude type.
SEGMENTING

❖ Described as “divide and conquer.”

❖ An estimate is decomposed into its individual

components, estimates are made at those
lower levels, and then the estimates are
aggregated (added) back together.
COST INDEXES

❖ Cost indexes are numerical values that reflect

historical change in engineering (and other)
costs.
❖ Dimensionless.
❖ Reflect relative price change
POWER SIZING
MODEL

❖ Used to estimate the costs of industrial plants

and equipment.
❖ The model “scales up” or “scales down”
known costs
TRIANGULATION

❖ Might involve using different sources of data or using

different quantitative models
❖ We should approach our economic estimate from
different perspectives because such varied perspectives
add richness, confidence, and quality to the estimate.
 General
Economic
Environment
ECONOMICS = PEOPLE + WEALTH
ENGINEERING = COST-EFFICIENT + SCIENTIFIC KNOWLEDGE → MANKIND

50
 Consumer and Producer
Goods and Services

❖ Consumer goods and services

❖ Producer goods and services

Sample Footer Text 51

 Measures of Economic
Worth

❖Goods and services are produced and

desired because they have utility—the
power to satisfy human wants and
needs.

Sample Footer Text 52

 Necessities, Luxuries,
and Price Demand

❖Goods and services may be divided into

two types:
necessities and luxuries

❖ Theory of Supply and Demand

Sample Footer Text 53

 Competition
❖ A perfect competition occurs in a situation in
which any given product is supplied by a large
number of vendors and there is no restriction
on additional suppliers entering the market.

❖ A perfect monopoly exists when a unique

product or service is only available from a
single supplier and that vendor can prevent the
entry of all others into the market.

Sample Footer Text 54

 The Total Revenue
Function

Total Revenue is the product of the

selling price per unit and the
number of units sold

Sample Footer Text 55

 Cost, Volume, and
Breakeven Point
Relationships
❖ Fixed costs remain constant
over a wide range of activities,
but variable costs vary in total
with the volume of output

Sample Footer Text 56