MDP 3310
Project Planning and Economics
Lecture #7
Types of Costs and Cost Structures in Engineering Projects
Today’s lecture
Types of costs
Elements of product cost
Material cost
Effect of material and product shapes on material cost
Design for Manufacturing and material cost
Labor cost
Methods for labor remuneration (compensation)
Overheads
Overhead application rates
2
Types of costs
Cost concepts, definitions and classifications
Elements of Product price
Types of costs:
Costs relationship to volume
Costs relationship to manufacturing facilities
Costs relationship to planning, controlling and
decision making
What is cost?
Cost is the “value” of the sacrifice made to acquire
goods or services, measured in monetary units at
the time the benefits are acquired.
At the time of acquisition, the cost incurred is for
present or future benefits. When these benefits
are utilized, the costs become expenses.
An expense is defined as a cost that has given a
benefit and is now expired.
Un-expired costs that can give future benefits are
classified as assets.
Revenue and Loss
Expenses are matched against revenue to
determine net income or loss for a period. Revenue
is defined as the price of products sold or services
rendered.
In certain instances, the goods or services
purchased become valueless without having
provided any benefit. These costs are called losses.
If some of the purchased goods are sold and
generated revenue, while the rest become
valueless, the net loss is calculated as the difference
between the revenue and the total cost.
Elements of Product Price
Direct material
Prime cost
Direct labor
Cost of goods
Indirect material manufactured
Factory or
Indirect labor manufacturing
overheads Cost of
production
Other indirect
Selling price manuf. costs Cost of
goods sold
General and
administrative
overheads
Selling and
marketing
overheads
Profit
Costs relationship to volume
Fixed costs: are those constant costs that do not
change/vary with the change in the rate of
output. Examples: insurance and taxes on
buildings and utilities, general management and
administrative salaries, license fees.
Variable costs: are those costs which change/vary
with the change in the rate of output. Examples:
material and labor costs of a certain product.
Mixed costs: are those costs containing both fixed
and variable characteristics over various relevant
ranges of operation.
Costs relationship to manufacturing
facilities
Operating and maintenance (O&M) cost: includes
all costs required to operate and maintain a
facility over its useful life
First cost: the total initial investment required to
get the facility ready for service or use. Includes:
installation costs, and related insurance costs.
Disposal cost: Includes costs required for removal
and replacement of a facility.
Salvage value: The net worth of a facility at time
of disposal.
Costs relationship to planning, controlling
and decision making
Short-run costs: are those costs associated with variation
in the level of the utilization of fixed facilities.
Long-run costs: are those costs associated with variation
in the size of kind of plant or facility.
Sunk cost: The past expenditures that cannot be retrieved
or recovered. 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.
Opportunity cost: The sacrifice of a return from a rejected
alternative is called the opportunity cost of the accepted
alternative.
Material Cost
10
Effect of material and product shapes on
material cost
Raw material is purchased to manufacture the
design. How much material is necessary and what
it will cost are two important questions.
Three different quantities of material are
involved:
The amount of raw material needed to manufacture
the design
The amount of material theoretically composing the
design (part shape)
The difference between the above two, which is loss
during manufacturing processing.
Effect of material and product shapes on
material cost (cont.)
Shape describes the amount of material in a
design. It can be measured in units of weight,
volume, area or length.
Design makes two calculations: (1) finding the
shape and (2) optimizing the shape with raw
material.
Based on a given design, the shape can be
measured using traditional methods or using
modern software packages (ProE for instance)
• For example, the above shape can be produced using casting.
The shape (volume) needed to produce it can be calculated
from the shape dimensions. The gating, sprues and risers add
to the total volume of the final design additional volume
needed from the raw material.
• The part shape is the desired minimum amount of material
Waste, Scrap and Shrinkage
Waste is the difference between the raw material
used and the part shape. It includes chips that are
cut away during machining, sprues and runners
that are cut off after casting, and the trimmed
edges during stamping.
Scrap is faulty material caused by human mistake
or equipment malfunction. For example,
mislocation of drilled holes is a shop mistake.
Shrinkage is the loss of material because of theft
or physical laws. For example, polymer material
has limited shelf life, rusting of ferrous material.
Additive processes
The total amount of material required to manufacture the part, called the
starting shape (Ss) can be determined by figuring for the losses in addition to
the final part shape (Sf). The following formula can be used for additive type
processes such as molding and casting.
Ss = (Sf + L1) × (1 + L2 + L3)
Where:
Ss : starting shape (measured in units of length/area/volume/weight..)
Sf : final part shape (measured in units of length/area/volume/weight..)
L1 : loss due to waste (measured in units of length/area/volume/weight..)
L2 : loss due to scrap (fractional)
L3 : loss due to shrinkage (fractional)
Subtractive Processes
For subtractive processes (machining, presswork,
and many more), the number of parts of Sf that
can be obtained from a single unit of procured
material (parts per sheet or bar) must be first
determined.
Then the number of units of purchased material
needed for the quantity of finished parts can be
calculated. Unusable material required for
clamping, the material lost separating parts, and
dressing ends must be included.
Subtractive Processes
For example, in sheet metal works, parts are to be cut
from a sheet metal with a given width and length
similar to the one shown in the following figure.
200 cm
80 cm
45 cm
300 cm
waste
Salvage value
For some materials and products, the scrap and waste
(called salvage), can be sold to a recycler or the original
supplier or it can sometimes be reused/recycled in
manufacturing process. In these cases, the value of the
salvage can offset part of the cost of the material.
Conversely, if the manufacturer must pay to have the
salvage taken away, this cost adds to the cost of the
material.
The salvage value (Vs) is computed as
Vs = (Ss – Sf) × Cs
Where Cs = salvage value in $/shape units
Cs is negative if there is a charge to have the salvage
material hauled away.
Salvage value (cont.)
If the salvage value is significant, then the
material cost calculation is:
Cdm = Ss Cms - Vs
Where
Cdm = cost of direct material, dollars per unit
Cms = cost of purchasing material, dollars per unit.
Overall efficiency of material conversion
It is possible to compute the overall efficiency of
the economic conversion of raw materials per
part by using the equation:
S f C ms V s
Em 100
S s C ms
Labor Cost
21
Methods of labor remuneration
(compensation)
There are two main methods on how to
determine the compensation amount for
workers:
1. Hourly-rate plans
2. Piece-rate plans
In addition to mixed plans.
Hourly-rate plan
In this plan, the compensation amount is
determined based on the number of hours/days
worked.
This means that no matter how high or low the
production rate is, the amount paid will not be
changed.
This method is commonly used in Egypt.
Advantages of hourly-rate plan
Easy to implement due to the simple calculations
needed.
Low administrative and accounting costs needed
Suitable for certain jobs in which the manual work
is not extensive or for jobs in which it is not easy
to measure the production rate.
Reduces stresses on labors
Disadvantages of hourly-rate plan
There is no distinction between hard and lazy
workers, which will result in reduction in the
labors’ skill levels
Reduction in the overall performance of the
production system as there is no incentive for
workers to increase their productivity, which will
eventually result in higher production costs.
Increased supervision effort by production
managers.
a) Standard time plan
E = Ha ⨯ Rh
Where:
E Earning
Ha Actual hours worked
Ra Wage base rate per hour
Example 1
Two workers are employed for LE50 per hour.
Worker A worked a total of 120 hours in May,
while worker B worked 160 hours. Calculate the
earning of each worker in May.
Solution:
Rh = 50 EGP/hr
Ha(A) = 120 hrs. and Ha(B) = 160 hrs.
↠ E(A) = 120x50 = EGP 6000
and E(B) = 160x50 = EGP 8000
b) Halsey plan
output up to standard ↠ E = Rh ⨯ Ha
output above standard ↠ E = Rh (Ha + Hsd / 2)
Where:
Hsd Hours saved
Example 2
In example 1, suppose that although worker A
worked 120 hours in May, he was efficient and
completed all tasks which were supposed to take
160 hours by an average worker.
In this case, if Halsey plan is applied, the earning
for worker A would be:
E(A) = 50x(120 + 40/2) = EGP 7000
c) Rowan premium plan
output up to standard ↠ E = Rh ⨯ Ha
output above standard ↠ E = Rh ⨯ Ha (1 + Hsd / Hst)
Where:
Hst Standard hours allowed
Example 3
In Example 2, the standard time for completing
the tasks assigned to worker A in May is 160
hours. Therefore, the earning for worker A using
Rowan premium plan is calculated as follows:
E(A) = 50x120x(1 + 40/160) = EGP 7500
Piece-rate plan
In this system, the compensation amount is
determined based on the production rate of a
labor or the average production rate for a group
or team of workers. The main idea behind this
system is to give motive to workers to increase
their productivity.
Advantages of the piece-rate plan
The existence of a motive for workers to improve
their productivity.
It is more fair as it differentiates between hard
and lazy workers
The increased benefit for the production system
as production rates increases and accordingly
lower costs can be achieved.
Disadvantages of the piece-rate plan
The increased stress on the workers, which may
affect their health.
The increased competition may create conflicts
among workers.
It may be difficult to implement, especially
whenever there is a sequence of operations that
depend on each other.
Increased cost accounting effort as accountants
must keep a record for each workers production
rate.
a) Straight piece-work system
E = Q ⨯ Rp
Where:
Q Quantity produced
Rp Money rate per piece (unit)
Example 4
Two workers A and B are compensated
according to the quantity they produce with a
rate of EGP40 per piece. If in a given month,
they produced 95 and 113 pieces respectively,
calculate the earning of each worker.
Solution:
Earning for worker A = E(A) = 40 x 95 = EGP
3800
Earning for worker B = E(B) = 40 x 113 = EGP
4520
b) Taylor system
output below standard ↠ E = Q ⨯ Rp
output at or above standard ↠ E = Q ⨯ Rph
where:
Rph High money rate per
piece
Example 5
In Example 4, if the standard output quantity
of an average worker is estimated as 100
pieces per month and the high money rate
per piece is EGP 41.5, re-evaluate the earnings
of workers A and B.
Solution:
Earning for worker A = E(A) = 40 x 95 = EGP
3800
Earning for worker B = E(B) = 41.5 x 113
= EGP 4689.5
Modified wage plans
Modified wage plans combine some features of
the hourly-rate and piece-rate plans.
An example of a modified wage plan would be to
set a minimum hourly wage that will be paid by
the company even if an established quota of
production is not attained by an employee. If he
established quota is exceeded, an additional
payment per piece would be added to the
minimum wage level.
Who decides?
The determination of the wage plan is not left for
the management to decide as labor unions play
an important role.
While management wishes to minimize costs and
maximize profits, labor unions attempt to
maximize the employee’s earnings.
So many variations of the hourly-rate and piece-
rate plans may exist.
Overheads
Accounting for factory overheads
Factory overhead refers to the cost pool used to
accumulate all indirect manufacturing costs
(excluding selling, general , and administrative
expenses because they are non-manufacturing
costs). Examples of factory overhead include the
following:
Indirect labor and indirect material
Heat, light, and power for the factory
Rent on factory building
Depreciation on factory building and factory equipment
Maintenance of factory building and factory equipment
Property taxes on factory building
Relevant range
There is an interval of activity within which total
fixed costs and per unit variable costs remain
constant. This interval is call the relevant range.
Categories
Factory overhead costs are divided into three categories on the basis
of their behavior in relation to production within the relevant range.
The categories are:
Variable factory overhead costs. Total variable factory overhead costs vary in
direct proportion to the level of production within the relevant range. This
means that the greater the number of units produced, the higher the total
variable factory overhead cost.
Fixed factory overhead costs. Total fixed factory overhead costs remain
constant within the relevant range regardless of the varying levels of
production within that range. Examples of fixed factory overhead costs are
property taxes, depreciation, and rent on the factory building.
Mixed factory overhead costs. Mixed factory overhead costs are neither
wholly fixed nor wholly variable in nature but have characteristics of both.
Mixed factory overhead costs must ultimately be separated in their fixed and
variable components for purposes of planning and control. Examples include
factory truck rentals (semivariable factory overhead costs) and factory
supervisors’ salaries and factory inspector salaries (step factory overhead
costs).
FOH application rates
Actual direct materials and direct labor are
recorded as used. Factory overhead cannot be
charged directly to work-in-process inventory as
costs occur because usually they do not occur
evenly throughout the process nor can they be
identified to a specific job or department.
Therefore, a predetermined factory overhead
application rate must be calculated, and used to
apply factory overhead to production as units are
produced.
FOH application rates
Factory overhead application rates are generally
stated in terms of dollars per unit of estimated activity
of some base (called the denominator activity).
There are no definitive rules for determining which
base to use as the denominator activity. However,
there must be a direct relationship between the base
and factory overhead costs.
The formula for computing the factory overhead
application rate, which is the same regardless of the
base chosen is as follows:
Estimated factory overhead costs
Factory overhead application rate per unit
Estimated base at denominator activity
FOH application rates
Before the factory overhead application rate can
be determined, the factory overhead costs (fixed,
variable and mixed) must be determined. This is
done by preparing a budget of the costs.
The bases that are commonly used to compute
the factory overhead application rates are: (1)
units of production, (2) direct materials cost, (3)
direct labor cost, (4) direct labor hours, and (5)
machine hours.
Example 6
The following is an illustration of computing a factory overhead
application rate using each of the five bases listed above. Note
that the numerator remains the same; only the denominator
changes with each method.
Estimated factory overhead costs EGP 1,500,000
Expected production 300,000 units
Estimated materials cost EGP 500,000
Estimated direct labor cost EGP 3,000,000
Estimated direct labor hours 200,000 hours
Estimated machine hours 30,000 hours
Example 6
Estimated factory overhead costs EGP 1,500,000
Expected production 300,000 units
Estimated materials cost EGP 500,000
Estimated direct labor cost EGP 3,000,000
Estimated direct labor hours 200,000 hours
Estimated machine hours 30,000 hours
(1) Units of production:
EGP 1,500,000
=EGP 5 per unit
300,000 units
EGP 1,500,000
(2) Direct materials cost: ×100=300 % of direct materials cost
EGP 500,000
EGP 1,500,000
(3) Direct labor cost: ×100=50 % of actual direct labor cost
EGP 3,000,000
(4) Direct labor hours: EGP 1,500,000 =EGP 7.50 per direct labor hour
200,000 hours
EGP 1,500,000
(5) Machine hours: =EGP 50 per machine hour
30,000 hours
