Bicol University

COLLEGE OF ENGINEERING
Legazpi City

Cost Concepts & Design

MODULE 2
Economics
Overview
This module is a continuation of the introduction to engineering economics. This covers a
definitions of cost terminologies and rules on present economic studies.

Lesson Objectives
At the end of this lesson, the student should be able to:
1. Clearly define cost terminologies and differentiate them from one another;
2. Apply the different cost terminologies in economic studies; and
3. Understand and conduct present economic studies.

Lesson Outline
1. Cost Terminology
2. The General Economic Environment
3. Present Economic Studies

2.1. Cost Terminology

2.1.1. FIXED, VARIABLE, INCREMENTAL & AVERAGE COSTS

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FIXED COSTS
A fixed cost is a cost that is constant or unchanging regardless of the level of output
or activity over a feasible range of operations for the capacity or capability available.
Fixed costs are expenses that have to be paid by the company, independent of any
specific business activities. Typical fixed costs include rental lease payments, general
management and administrative salaries, insurance and taxes on facilities, interest
costs on borrowed capital, depreciation, license fees, and potentially some utilities.

VARIABLE COSTS
A variable cost, on the other hand, is a cost that depend on the level of output or
activity. Variable costs increase or decrease depending on the company’s production
volume; they rise as production increases and fall as production decreases. For
example, the costs of raw materials and labor used in a product or service are variable
costs, because they vary in total with the number of output units, even though the costs
per unit stay the same.

INCREMENTAL COSTS
Incremental cost is the total cost that results from increasing the output of a
system by one (or more) units. In other words, it is the amount of money it would cost
a company to make an additional unit of product. Incremental cost is often associated
with “go – no go” decisions that involve a limited change in output or activity level.
Understanding incremental costs can help boost production efficiency and profitability,
but it is often quite difficult to determine in practice.

AVERAGE COSTS
Average cost is the per unit cost of production obtained by dividing the total cost
by the total output. By cost of production, we mean that all fixed and variable costs are
taken into consideration for calculating the average cost. Thus, it is also called the per
unit total cost.

2.1.2. DIRECT, INDIRECT & STANDARD COSTS

DIRECT COSTS
Direct costs are costs which are directly accountable to a cost of a specific output
or work activity, that is, costs that can be reasonably measured and allocated to a

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[BES 12] Engineering Economics 2.1 Cost Terminology

specific output or work activity. Examples of direct costs are material and labor costs
directly associated with a product, service or construction activity.

INDIRECT COSTS
Indirect costs are costs that are not directly accountable to a cost of a specific
output or work activity, that is, costs that are not directly related to and are difficult to
allocate to a specific output or work activity. Indirect costs may either be fixed or
variable. Normally, they are costs allocated through a selected formula (such as
proportional to direct labor hours, direct labor costs, or direct material costs) to the
outputs or work activities. Some indirect costs may be overhead. Examples of indirect
costs are the costs of common tools, general supplies, and equipment maintenance in a
plant.

STANDARD COSTS
Standard costs are planned costs per unit of output that are established in advance
of actual production or service delivery. Rather than assigning the actual costs of
material, labor and overhead to the output, the company assign the anticipated (or
expected) or standard costs.

2.1.3. CASH COST vs BOOK COST

CASH COSTS
Cash costs are costs that involve payment of cash and results in a cash flow. For
example, it a company purchases an asset, it realizes a cash cost. Cash costs are
estimated from the perspective established for the analysis and are the future expenses
incurred for the alternatives being analyzed.

BOOK COSTS
Book costs are noncash costs. These are costs that does not involve a cash
transaction (and cash flow), but is an accounting entry that represents some change in
value – a recovery of past expenditures over a fixed period of time. The most common
example of book cost is the depreciation charged for the use of assets.

2.1.4. SUNK COSTS vs PROSPECTIVE COST

SUNK COSTS

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A sunk cost is a cost that has already been incurred and cannot be recovered as a
result of past decision. Sunk cost is a sum paid in the past are no longer relevant to
estimates of future costs or revenues related to an alternative course of action.

PROSPECTIVE COSTS
A prospective cost is a future cost that may be incurred, avoided or changed if an
action is taken – whether or not the cost is paid depends on some action.

2.1.5. OPPORTUNITY COSTS

An opportunity cost is the foregone benefit that would have been derived by an
option not chosen. When these benefits are not chosen, the become costs. Opportunity
costs are associated with using a resource in one activity instead of another. These are
costs 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. Thus, these are
costs of the best rejected (i.e. foregone) opportunity and is often hidden or implied.

2.1.6. RECURRING AND NONRECURRING COSTS

RECURRING COSTS
Recurring costs refer to any expense that is known and anticipated, and that
occurs at regular intervals. An example of recurring costs are annual expenses for
operation and maintenance of a plant.

NONRECURRING COSTS
Nonrecurring costs, on the other hand, are one-of-a-kind expenses that occurs at
irregular intervals, and thus are sometimes difficult to anticipate or plan for from a
budgeting perspective. Examples of nonrecurring costs, in contrast with the example
for recurring costs, are the cost of installation of new machine (including any facility
modifications required), the cost of augmenting equipment based on older technology
to restore its usefulness, emergency maintenance expenses, and the disposal or close-
down costs associated with ending operations.

2.1.7. LIFE-CYCLE COSTS

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Life-cycle cost is defined as the sum of all costs over the full life span or a specified
period of a product, 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.
Life cycle costing is an important economic analysis used in the selection of
alternatives that impact both pending and future costs. It refers to the concept of
designing products and services with a full and explicit recognition of the associated costs
over the various phases of their life cycles. Also, it compares initial investment options
and identifies the least cost alternatives. Figure 2.1 provides a brief graphical description
of the phases of the life cycle and their relative cost.

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Figure 2.1 Typical Phases of the Life Cycle of Products or Services

and their Relative Cost

2.1.8. INTERNAL & EXTERNAL COSTS

INTERNAL COSTS
Internal cost refers to the direct monetized costs for a company or individual
undertaking a specific work activity. It includes costs like materials, labor, planning,
maintenance, operation, management and overheads. For example, when a person
purchases fuel for a car, he pays for the production of that fuel which is considered an
internal cost.

EXTERNAL COSTS
External cost refers to the economic concept of uncompensated social or
environment effects. For example, people buying fuel for a car does not pay for the costs
of burning the fuel, such as air pollution. The aim of the “polluter pays” principle and
environmental taxes is that these external costs are internalized (i.e., made an internal
cost) (e.g. by putting an eco-tax on fuels).

2.2. The General Economic Environment

2.2.1. CONSUMER AND PRODUCER GOODS AND SERVICES
Goods and services that are produced and utilized may be divided into two classes
– consumer goods and services, and producer goods and services.
Consumer goods and services are products and services that are directly used by
people to satisfy their needs and wants. Examples of these are food, clothing, homes, car,
medical and dental services, and theater. The providers of consumer goods and services
must be aware of, and are subject to, the changing wants of the people to whom their
products are sold.
Producer goods and services, on the other hand, are used to produce consumer
goods and services or other producer goods. Examples of these are machine tools, factory
buildings, trucks and farm machinery. The amount of producer goods needed is
determined indirectly by the amount of consumer goods or services that are demanded
by the people.

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[BES 12] Engineering Economics 2.2 The General Economic Environment

2.2.2. MEASURES OF ECONOMIC WORTH

Goods and services are produced and desired because they have utility – the power
to satisfy human wants and needs. Thus, they may be used or consumed directly, or they
may be used to produce other goods or services. Utility is most commonly measured in
terms of value, expressed in some medium of exchange as the price that must be paid to
obtain the particular item.

2.2.3. NECESSITIES, LUXURIES, AND PRICE DEMAND

Goods and services may be divided into two types: necessities and luxuries. These
terms are relative because for most goods and services, what one person considers a
necessity may be considered a luxury by another.
For all goods and services, there is a relationship between the price that must be
paid and the quantity that will be demanded or purchased. The relationship between
price and demand can be expressed as the linear function

= − for 0 ≤ ≤ , and > 0, > 0,

where is the intercept on the price, and is the slope or the amount by which demand
increases for each unit decrease in .

2.2.4. COMPETITION
Under a mixed economy, businesses make decisions about which goods to produce
or services to offer and how they are priced. Because there are many businesses making
goods or providing services, customers can choose among a wide array of products. The
competition for sales among businesses is a vital part of our economic system.
Economists have identified four types of competition in a free market system – perfect
competition, monopolistic competition, oligopoly, and monopoly.

PERFECT COMPETITION
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. Because no seller is big enough or influential enough to affect
price, sellers and buyers accept the going price. Under such conditions, there is
assurance of complete freedom on the part of both buyer and seller. Perfect
competition may never occur in actual practice, because of a multitude of factors that

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Instructor | [email protected]
NATANAEL B. ORTIZ, REE
Instructor I | [email protected]
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Cost Concepts & Design Economics [BES 18] Engineering Economics

impose some degree of limitation upon the actions of buyers or sellers, or both.
However, with conditions of perfect competition assumed, it is easier to formulate
general economic laws.
MONOPOLISTIC COMPETITION
Under monopolistic competition, many sellers offer differentiated products –
products that differ slightly but serve similar purposes. By making consumers aware of
product differences, sellers exert some control over price.

MONOPOLY
In a monopoly, there is only one seller in the market. The market could be a
geographical area, such as a city or a regional area, and does not necessarily have to be
an entire country. The single seller is able to control prices.
There are two general types of monopolies – natural and legal monopolies.
Natural monopolies include public utilities, such as electricity and gas suppliers. They
inhibit competition, but they’re legal because they’re important to society. A legal
monopoly arises when a company receives a patent giving it exclusive use of an
invented product or process for a limited time, generally twenty or fifty years.

OLIGOPOLY
In an oligopoly, a few sellers supply a sizable portion of products in the market.
They exert some control over price, but because their products are similar, when one
company lowers prices, the others follow.

2.2.5. TOTAL REVENUE

Total revenue (TR) is the total receipts a seller can obtain from selling goods or
services to buyers. It is the product of the selling price per unit, , and the number of units
sold, . Thus,

TR = price × demand = ⋅

If the relationship between price and demand in Sect. 2.2.3 is used,

=( − ) = − for 0 ≤ ≤ , and > 0, > 0.

The maximum total revenue in the equation presented may be obtained, thru calculus,
by solving

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[BES 12] Engineering Economics 2.2 The General Economic Environment

= −2 = 0.

Thus,

= .
2
It must be emphasized that, because of cost–volume relationships, most businesses
would not obtain maximum profits by maximizing revenue. Accordingly, the cost–volume
relationship must be considered and related to revenue, because cost reductions provide
a key motivation for many engineering process improvements.

2.2.6. COST, VOLUME, AND BREAKEVEN POINT RELATIONSHIPS

At any demand, D, the total cost is

= +

where and denote fixed and variable costs, respectively. For the linear relationship
assumed here,

= ⋅ ,

where is the variable cost per unit.

We shall consider two scenarios for finding breakeven points. In the first scenario,
demand is a function of price. The second scenario assumes that price and demand are
independent of each other.

SCENARIO 1 : When total revenue, as given by the equation in the previous section,
and total cost, as given in the equations above, are combined, the typical results as a
function of demand are depicted in Figure 2.2. At breakeven point D'1, total revenue
is equal to total cost, and an increase in demand will result in a profit for the
operation. Then at optimal demand, D, profit is maximized. At breakeven point D′2,

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Instructor | [email protected]
NATANAEL B. ORTIZ, REE
Instructor I | [email protected]
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Cost Concepts & Design Economics [BES 18] Engineering Economics

Figure 2.2 Combined Cost and Revenue Functions

and Breakeven Points, as Functions of Volume,
and their Effect on Typical Profit (Scenario 1)

total revenue and total cost are again equal, but additional volume will result in an
operating loss instead of a profit. Obviously, the conditions for which breakeven and
maximum profit occur are our primary interest. First, at any volume (demand), D,

Profit(loss) = total revenue − total costs

Profit(loss) = ( − )−( + )

Profit(loss) = − +( − ) − for 0 ≤ ≤ , and > 0, > 0.

In order for a profit to occur, based on the equation above, and to achieve the
typical results depicted in Figure 2.2, two conditions must be met:
1. ( − ) > 0; that is, the price per unit that will result in no demand has to be
greater than the variable cost per unit. (This avoids negative demand.)
2. Total revenue ( ) must exceed total cost ( ) for the period involved.

If these conditions are met, we can find the optimal demand at which maximum profit
will occur by taking the first derivative the equation with respect to D and setting it
equal to zero:

(profit)
= − −2 = 0.

The optimal value of D that maximizes the profit is

−
= .
2

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[BES 12] Engineering Economics 2.2 The General Economic Environment

To ensure that we have maximized profit (rather than minimized it), the sign of the
second derivative must be negative. Checking this, we find that

(profit)
= −2

which will be negative for > 0 (recall in basic calculus concepts that a negatively
signed second derivative is necessary to obtain a maxima).
An economic breakeven point for an operation occurs when total revenue equals
total cost. Then for total revenue and total cost, at any demand D,
Total revenue = total cost(breakeven point)
− = +
− +( − ) − =0

Because this is a quadratic equation with one unknown (D), we can solve for the
breakeven points D′1 and D′2 (the roots of the equation):

−( − ) ± ( − ) − 4(− )(− )
=
2(− )

With the conditions for a profit satisfied, the discriminant, (the radicand or the
expression inside the radical sign) ( − ) − 4(− )(− ), will be greater than zero,
or ( − ) > −4 . This will ensure that D′1 and D′2 have real positive, unequal
values.

SCENARIO 2 : When the price per unit (p) for a product or service can be represented
more simply as being independent of demand [versus being a linear function of
demand, as assumed in the preceding scenario] and is greater than the variable cost
per unit (cv), a single breakeven point results. Then, under the assumption that
demand is immediately met, total revenue TR = p · D. If the linear relationship for
costs is also used in the model, the typical situation is depicted in Figure 2.3.

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Instructor | [email protected]
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Instructor I | [email protected]
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 Cost Concepts & Design Economics [BES 18] Engineering Economics

Figure 2.3 Typical Breakeven Chart with Price ( ) a contant

(Scenario 2)

2.3. Present Economic Studies

Present economy studies are engineering economic analyses where alternatives for
accomplishing a specific task are being compared over one year or less and the influence of
time on money can be ignored. Listed below are rules, or criteria, that will be used to select
the preferred alternative when defect-free output (yield) is variable or constant among the
alternatives being considered.

RULE 1 : When revenues and other economic benefits are present and vary among
alternatives, choose the alternative that maximizes overall profitability based
on the number of defect-free units of a product or service produced.

RULE 2 : When revenues and other economic benefits are not present or are
constant among all alternatives, consider only the costs and select the
alternative that minimizes total cost per defect-free unit of product or service
output.

2.3.1. TOTAL COST IN MATERIAL SELECTION

In many cases, economic selection among materials cannot be based solely on the
costs of materials. Frequently, a change in materials will affect the design and processing
costs, and shipping costs may also be altered.
Care should be taken in making economic selections between materials to ensure
that any differences in shipping costs, yields, or resulting scrap are considered.
Commonly, alternative materials do not come in the same stock sizes, such as sheet sizes

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[BES 12] Engineering Economics 2.3 Present Economic Studies

and bar lengths. This may considerably affect the yield obtained from a given weight of
material. Similarly, the resulting scrap may differ for various materials.
In addition to deciding what material a product should be made of, there are often
alternative methods or machines that can be used to produce the product, which, in turn,
can impact processing costs. Processing times may vary with the machine selected, as
may the product yield.

2.3.2. MAKING vs PURCHASING (OUTSOURCING) STUDIES

In the short run, say, one year or less, a company may consider producing an item
in-house even though the item can be purchased (outsourced) from a supplier at a price
lower than the company’s standard production costs. This could occur if (1) direct,
indirect, and overhead costs are incurred regardless of whether the item is purchased
from an outside supplier and (2) the incremental cost of producing an item in the short
run is less than the supplier’s price. Therefore, the relevant short-run costs of make
versus purchase decisions are the incremental costs incurred and the opportunity costs
of the resources involved.
Opportunity costs may become significant when in-house manufacture of an item
causes other production opportunities to be forgone (often because of insufficient
capacity). But in the long run, capital investments in additional manufacturing plant and
capacity are often feasible alternatives to outsourcing. (Much of this book is concerned
with evaluating the economic worthiness of proposed capital investments.) Because
engineering economy often deals with changes to existing operations, standard costs may
not be too useful in make-versus-purchase studies. In fact, if they are used, standard costs
can lead to uneconomical decisions.

KIM ARVIN P. LEOCADI O, REE

Instructor | [email protected]
NATANAEL B. ORTIZ, REE
Instructor I | [email protected]
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