IPPC-403 Engineering Economy

Rakesh K.Sharma 1
Associate Professor
Department of Industrial and Production Engineering
Dr. B.R. Ambedkar National Institute of Technology Jalandhar
Jalandhar

Note: The images used in this ppt are reproduced from various resources on internet for the sole purpose of teaching to B.Tech. students.
At the end of this lecture, the students will be
able to distinguish different types of costs.

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 Cost is "a foregoing, measured in monetary terms,
incurred or potentially to be incurred to achieve a
specific objective" (American Accounting Association).
 Cost refers the monetary measure of the amount of
resources given up or used for some specified purpose.
It is the value the goods or services expended to obtain
current or future benefits.
 Management accountants need to understand cost
concepts because they are vital in all areas of planning,
control, and decision-making.
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Costs can be classified in different ways. There are
 manufacturing costs and non-manufacturing costs (According to functions),
 direct and indirect costs (According to ease of traceability),
 product and period costs (According to timing of charge against revenue),
 fixed and variable (According to cost behavior),
 Recurring and non-recurring (According to the frequency of incurrence),
 controllable and uncontrollable costs,
 Capital expenditures, Revenue expenditures,
 Cash cost and book cost,
 Life-cycle cost,
 others: Relevant Cost, Standard Cost, Opportunity Cost, Sunk Cost, Differential
Cost, Marginal Cost, Imputed Cost, Replacement Cost, Out-of-pocket Cost
(According to relevance to decision making)
 etc.
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Different activities/functions are carried out to obtain useable goods and
services from raw materials. Costs can be classified accordingly.

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RS2

1. Manufacturing costs - incurred in the factory to convert raw materials into

finished goods.
It includes
 cost of raw materials used (direct materials),
 direct labor, and
 factory overhead*.

Manufacturing Cost
*Factory overhead is the costs incurred during the manufacturing process, not including the costs of direct labor and direct materials.
Factory overhead is normally aggregated into cost pools and allocated to units produced during the period. It is charged to expense
Non-manufacturing Cost when the produced units are later sold as finished goods or written off. 6
Slide 6

RS2 Examples of factory overhead costs are noted below:

Production supervisor salaries

Quality assurance salaries

Materials management salaries

Factory rent

Factory utilities

Factory building insurance

Fringe benefits

Depreciation

Equipment setup costs

Equipment maintenance

Factory supplies

Factory small tools charged to expense

Insurance on production facilities and equipment

Property taxes on production facilities

Rakesh Sharma, 30-09-2024
 2. Non-manufacturing costs - not incurred in transforming materials to
finished goods.
These include
 selling expenses (such as advertising costs, delivery expense, salaries and commission of
salesmen) and
 administrative expenses (such as salaries of executives and legal expenses).

Manufacturing Cost

Non-manufacturing Cost 7
Cost is divided into direct and indirect cost in terms of degree of traceability to
cost object i.e. product or job.

Direct Cost

Indirect Cost

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 Direct Costs – These are the costs that are clearly identifiable and traceable to
a costing object, such as units of product, company segments or some other
specific activity.
If output units are the objects of costing, then direct costs represent costs and
resources that can be traced to or identified with the finished product. Direct
materials, direct labour and other direct expenses are examples of direct costs.
Some operating expenses can also be classified as direct costs, such as
advertising cost for a particular product.

Direct Cost

Indirect Cost 9
 Indirect costs – These are the costs which cannot be identified with, or traced
to a single product because they are common to several products.
The example of indirect costs are: indirect materials (lubricants and scrap
material), salary of factory supervisors (indirect labour), rent, rates and de-
preciation (indirect expenses).
Indirect costs are often referred to as overheads. Overhead costs are indirect
costs with respect to a specific product since they are incurred for all products
manufactured in a company.

Direct Cost

Indirect Cost 10
What is a direct cost for one purpose, may be an
indirect cost for another purpose.
Costs which are indirect for a product, may be traced to a
segment or department and thus, will be direct costs for
that department. A segment may mean any one of a
number of things, viz., department, division, specific
activity, sales territory and the like. For example, the
salary of the plant manager of Plant A is a direct cost of
plant A. But if multiple products are produced in plant A,
the manager’s salary is indirect to the specific products. 11
Indirect costs (overhead costs) by nature create problems in cost
determination and analysis.
Direct cost related with a product can be measured with a high degree of accuracy.
In the absence of appropriate direct measurement techniques, indirect costs have
to be apportioned to different products. For example, suppose in a manufacturing
concern there are three separate production departments and a Head Office of the
company. Each of these four segments will have costs which can be directly traced
to their own departments. The direct or traceable costs of departments can be
identified with the help of source documents and accounting records. What portion
of the company Head Office expenses should be charged to different departments?
Since the Managing Director’s salary and other Head Office expenses benefits all
three operating departments, these costs should be charged to all three
departments. These indirect costs can be traced to different production
departments only by apportionment involving some formula or base which may not
be 100% accurate and reliable. 12
Cost is divided into product cost and period cost according to when it is
charged against revenue.
The key difference between product costs and period costs is that product
costs are only incurred if products are acquired or produced, and period costs
are associated with the passage of time. Thus, a business that has no
production or inventory purchasing activities will incur no product costs, but
will still incur period costs.

Product Cost

Period Cost
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 1. Product costs - are inventoriable costs. They form part of inventory and are
charged against revenue, i.e. cost of sales, only when sold.
Product costs are initially recorded within the inventory asset. Once the related
goods are sold, these capitalized costs are charged to expense. This accounting
is used to match the revenue from a product sale with the associated cost of
goods sold, so that the entire effect of a sale transaction appears within one
reporting period’s income statement.
All manufacturing costs (direct materials, direct labor, and factory overhead)
are product costs.

Product Cost

Period Cost 14
 2. Period costs - These are not inventoriable and are charged against revenue
immediately. Period costs are not assigned to one particular product or the
cost of inventory like product costs. Therefore, period costs are listed as an
expense in the accounting period in which they occurred.
Period costs include non-manufacturing costs, i.e. selling expenses and general
& administrative expenses such as rent, office depreciation, office supplies,
and utilities. Also, interest expense on a company's debt would be classified as
a period cost.

Product Cost

Period Cost 15
Categories of Period Costs and Product Costs
 Period costs are sometimes broken out into additional subcategories
 for selling activities and
 for administrative activities.
Administrative activities are the most pure form of period costs, since
they must be incurred on an ongoing basis, irrespective of the sales
level of a business.
Selling costs can vary somewhat with product sales levels, especially
if sales commissions are a large part of this expenditure.
 Product costs are sometimes broken out into two subcategories
 the variable and
 the fixed.
This additional information is needed when calculating the break
even sales level of a business. It is also useful for determining the
minimum price at which a product can be sold while still generating a
profit.
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Depending upon level of activity or volume, certain different costs behave in different
manner.
Certain costs may change with the change in activity level and certain costs may remain
fixed. Based upon this cost behaviour, costs can be classified as fixed costs, variable
costs and mixed costs.
Level of activity or volume can be measured in number of units produced, number of
machine working hours, sales in money/physical units etc.
This classification is important for a PPC manager.

Fixed Costs

Variable Costs

Mixed Costs 17
 1. Fixed costs - costs that remain constant regardless of the level of activity or
volume.
Examples include rent, insurance, property tax and depreciation using the
straight line method.
Note that fixed cost per unit decreases with increase in the level of activity or
volume though total fixed cost remains same.

Fixed Costs

Variable Costs

Mixed Costs 18
 2. Variable costs - vary in total in proportion to changes in activity or volume.
Examples include direct materials, direct labor, and sales commission based
on sales.
Note that the total variable cost will vary in direct proportion to the changes in
volume whereas variable cost per unit remains the same.

Fixed Costs

Variable Costs

Mixed Costs 19
 3. Mixed costs - costs that vary in total but not in proportion to changes in
activity or volume. It basically includes a fixed cost portion plus additional
variable costs.
An example would be electricity expense, telephone charges, maintenance
expenditure, depreciation etc. that consists of a fixed amount plus variable
charges based on usage.
It can be noted that as the organization goes on consuming more units (e.g. of
electricity), variable cost will increase, thus, causing an increase in total cost
whereas fixed cost will remain same up to a certain level.

Fixed Costs

Variable Costs

Mixed Costs 20
 When cost behavior is discussed, an assumption must be made about
operating levels. At certain levels of activity, new machines might be needed,
which results in more depreciation, or overtime may be required of existing
employees, resulting in higher per hour direct labor costs. The definitions of
fixed cost and variable cost assumes the company is operating or selling within
the relevant range (the shaded area in the graphs) so additional costs will not
be incurred.

Fixed Costs

Variable Costs

Mixed Costs 21
Relevant Cost There are certain cost concepts which engineers and
managers use for making various decisions.
Standard Cost
Opportunity Cost
Sunk Costs
Differential Cost
Marginal Cost
Imputed Cost
Replacement Cost
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Out-of-pocket Cost
Relevant Cost Relevant cost is a term that describes avoidable costs
that are incurred only when making specific business
decisions. The concept of relevant cost is used to
Standard Cost eliminate unnecessary data that could complicate the
decision-making process.
Opportunity Cost As an example, relevant cost is used to determine
whether to sell or keep a business unit, whether to make
Sunk Costs or buy parts or labor, and whether to accept a
customer's last-minute or special orders.
Differential Cost Example of Relevant Cost:
Assume, for example, a passenger rushes up to the ticket counter to
Marginal Cost purchase a ticket for a flight that is leaving in 25 minutes. The airline needs
to consider the relevant costs to make a decision about the ticket price.
Almost all of the costs related to adding the extra passenger have already
Imputed Cost been incurred, including the plane fuel, airport gate fee, and the salary and
benefits for the entire plane’s crew. [Because these costs have already been
incurred, they are "sunk costs" or irrelevant costs. Discussed later]
Replacement Cost The only additional cost is the labor to load the passenger’s luggage and any
food that is served mid-flight, so the airline bases the last-minute ticket
pricing decision on just a few small costs. 23
Out-of-pocket Cost
Relevant Cost A standard cost is an estimated expense that normally
occurs during the production of a product or
performance of a service. In other words, this is
Standard Cost theoretically the amount of money a company will
have to spend to produce a product or perform a
Opportunity Cost service under normal conditions.
Standard costs are sometimes referred to as “preset
Sunk Costs costs” because they are estimated based on statistics
and management’s experience. Basically,
Differential Cost management calculates how much each step in the
production process should cost based on the market
Marginal Cost value of goods, median wages paid per employee, and
average utility rates. This estimated calculated
Imputed Cost amount is the standard cost. It’s the amount that the
company should have to pay to produce a good.
Replacement Cost It is compared with the actual cost so that anomalies
are readily detectable.
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Out-of-pocket Cost
Relevant Cost Opportunity costs represent the potential benefits an
individual, investor, or business misses out on when
choosing one alternative over another. The idea of
Standard Cost opportunity costs is a major concept in economics.
Opportunity Cost Because by definition they are unseen, opportunity
costs can be easily overlooked if one is not careful.
Understanding the potential missed opportunities
Sunk Costs foregone by choosing one investment over another
allows for better decision-making.
Differential Cost
Opportunity Cost=FO−CO
Marginal Cost where: FO=Return on best foregone option
CO=Return on chosen option
Imputed Cost
Replacement Cost Opportunity costs are not recorded in accounting
records, but the analysis of these costs is important
Out-of-pocket Cost for making a decision. 25
Relevant Cost A sunk cost refers to money that has already been
spent due to the decisions taken in the past and
Standard Cost cannot be recovered. These are also called “Historical
Costs” or “Irrelevant Costs”.
Opportunity Cost In business, the axiom that one has to "spend money
to make money" is reflected in the phenomenon of the
Sunk Costs sunk cost. A sunk cost differs from future costs that a
business may face, such as decisions about inventory
Differential Cost purchase costs or product pricing.
Marginal Cost Sunk costs are excluded from future business
decisions because the cost will remain the same
Imputed Cost regardless of the outcome of a decision.
Sunk costs are not totally irrelevant as these become
Replacement Cost the basis for predicting costs for the future.
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Out-of-pocket Cost
 Differential cost (or incremental cost) is the difference
Relevant Cost between the cost of two alternative decisions, or of a
change in output levels. The concept is used when there
Standard Cost are multiple possible options to pursue, and a choice
must be made to select one option and drop the others.
Opportunity Cost Example of alternative decisions. If you have a decision
to run a fully automated operation that produces
100,000 widgets per year at a cost of $1,200,000, or of
Sunk Costs using direct labor to manually produce the same number
of widgets for $1,400,000, then the differential cost
between the two alternatives is $200,000.
Differential Cost
A differential cost can be a variable cost, a fixed cost, or
a mix of the two – there is no differentiation between
Marginal Cost these types of costs, since the emphasis is on the gross
difference between the costs of the alternatives or change
Imputed Cost in output.
Since a differential cost is only used for management
Replacement Cost decision making, there is no accounting entry for it.
There is also no accounting standard that mandates how
the cost is to be calculated. 27
Out-of-pocket Cost
Relevant Cost The marginal cost of production is the change in total
production cost that comes from making or producing
Standard Cost one additional unit.
The purpose of analyzing marginal cost is to
Opportunity Cost determine at what point an organization can achieve
economies of scale to optimize production and overall
Sunk Costs operations.
Differential Cost If the marginal cost of producing one additional unit
is lower than the per-unit price, the producer has the
Marginal Cost potential to gain a profit i.e. A company that is looking
to maximize its profits will produce up to the point
Imputed Cost where marginal cost (MC) equals marginal revenue
(MR).
Replacement Cost
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Out-of-pocket Cost
Relevant Cost There are certain costs which do not lead to any cash
outflow from the organization. These are considered only
for profit planning and decision making.
Standard Cost
It is incurred by virtue of using an asset instead of
Opportunity Cost investing it or the cost arising from undertaking an
alternative course of action.
Sunk Costs It is an invisible (implicit) cost that is not incurred
directly, as opposed to an explicit cost, which is incurred
Differential Cost directly. These do not appear on financial statements
and are also known as "implicit costs," "implied costs," or
Marginal Cost "opportunity costs” or “notional costs”.
Example: Suppose a company owns an office building in the city where managerial and
Imputed Cost administrative staff work. The company's manufacturing site is located outside the city.
The company could decide to relocate the workers to the manufacturing location and sell
or rent the city office building.
Replacement Cost The imputed costs, in this case, are the proceeds from the sale of the building or the
amount of rental income the company could earn from leasing it to another party. The
staff stays put, and only explicit costs associated with using the building, such as 29
Out-of-pocket Cost maintenance, utilities, and depreciation, are booked on the income statement.
Relevant Cost Replacement cost is a term referring to the amount of
money a business must currently spend to replace an
Standard Cost essential asset like a real estate property, an
investment security, a lien, or another item like plant
Opportunity Cost and machinery, vehicles etc. with one of the same or
higher value.
Sunk Costs  The cost to replace an asset can change, depending
on variations in the market value of components
Differential Cost used to reconstruct or repurchase the asset and
other costs needed to get the asset ready for use.
Marginal Cost
 Companies look at the net present value and
Imputed Cost depreciation costs when deciding which assets need
to be replaced and whether the cost is worth the
Replacement Cost expense.
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Out-of-pocket Cost
Relevant Cost All those costs which require cash outflows, at
present and in near future, are termed as out-of-
Standard Cost pocket costs.
Wages, electricity charges, salaries, rent, repair and
Opportunity Cost maintenance costs are various types of out-of-pocket
costs as cash outflows are involved.
Sunk Costs
Note this that depreciation is not an out-of-pocket
Differential Cost cost as it does not involve cash outflow.

Marginal Cost
Imputed Cost
Replacement Cost
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Out-of-pocket Cost
Based on the frequency of their incurrence, the costs incurred by an
organization are divided into two categories – recurring and non-recurring
expenses/costs.

Recurring Costs

Non-recurring
costs

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 Recurring costs are those expenses that are incurred as part of regular, routine and
ongoing business operations of the entity. To ensure continued business operations,
these expenses are therefore incurred frequently on a periodic basis.
Recurring expenses include a wide range of expenses, such as:
 Expenses required for day-to-day office work such as consultant retainer costs, ERP
subscriptions, office electricity, communication expenses and staff salaries etc.
 Expenses required for property maintenance such as rent of factory and office,
maintenance charges, depreciation and housekeeping costs etc.
 Expenses needed for product marketing and advertising activities such as marketing
agency fees and advertisement costs etc.
 Rrequired for sales and distribution of goods like transporters’ payments and
distributors commission etc.
Recurring expenses are fairly predictable as they are incurred as per pre-determined
Recurring Costs
schedule, making them amenable to estimation. They are, thus considered while preparing
and implementing entities’ expense budgets. These expenses are clubbed into several
expense heads and are recorded accordingly, either in the trading account or profit and loss
Non-recurring costs
account of the entity. 33
 Non-recurring expenses are those expenses which do not arise out of routine, day to
day business operations but instead are attributable to one-off or extraordinary
events. Non-recurring expenses are thus infrequent in nature and not expected to be
repetitive or reoccur at regular intervals.
Non-recurring expenses can be incurred due to several reasons which may include:
 Extraordinary events: costs incurred due to labor strike, losses on account of natural
calamities, restructuring costs and civil suit costs
 Changes in accounting principal: impairment losses, book adjustments to align with
new accounting rules
 Shutting down or starting up a department or a certain operation: closure expenses,
expansion costs like investment in a new facility and equipment etc.
Recurring Costs The exact nature of these expenses will determine whether they qualify as
revenue or capital. In either case, these expenses tend to be significant and
impact both profitability and cash flow. They are, thus, carved out and reported
Non-recurring costs
separately to draw management and stakeholders’ attention.
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 Recurring Costs Non-recurring Costs
Meaning Incurred periodically on Occur due to extraordinary or
account of regular, day to one-off circumstances.
day business operations.
Frequency On a periodic basis e.g. Not repetitive in nature e.g.
monthly rent and electricity loss due to flood, fire or
bill earthquake etc.
Cause routine business business or non-business
causes
Revenue or capital nature Revenue Revenue or Capital
Estimation Possible Generally not possible
Controllable Yes Less controllable
Cost accounting Allocated as overheads Generally do not form part of
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to product cost. product cost.
 Capital expenditures are typically one-time large purchases of fixed
assets that will be used for revenue generation over a longer period.
 Revenue expenditures are the ongoing operating expenses, which are
short-term expenses used to run the daily business operations.

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Cash cost is a cash transaction, or cash flow. For example, if a company
purchases an asset, it realizes a cash cost.
The term “cash cost” derives from ‘cash’ being given from one entity to another
such as persons, business organizations, banks, divisions, etc.). As in today’s
scenario of electronic banking capabilities cash costs may or may not involve real
‘cash.’
Book cost is not a cash flow, but it is an accounting entry that represents
some change in value. They characterize the revival of past expenditures over
a fixed period of time. Their provisions are made in the books of accounts to
include them in the profit and loss accounts and avail the tax advantages.
Simply, we can say that these are the payments that firm pays it to itself.
Depreciation, unpaid interest on owner’s fund or capital are some very
important and well known example of book cost.
When a company records a depreciation charge of Rs.4 Lacs in a tax year, no money changes
hands. However, the company is saying in effect that the market value of its physical, depreciable 37
assets has decreased by Rs.4 Lacs during the year.
Life-cycle cost (LCC) or Whole-life cost or Lifetime cost is the total cost of
ownership over the life of an asset. The concept is commonly referred to as
"cradle to grave" or "womb to tomb" costs.
Costs considered include the financial cost which is relatively simple to
calculate and also the environmental and social costs which are more difficult
to quantify and assign numerical values.
Typical areas of expenditure which are included in calculating the LCC include
planning, design, construction and acquisition, operations, maintenance,
renewal and rehabilitation, depreciation and cost of finance and replacement
or disposal.

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What is the purpose of a life cycle cost estimate?
Businesses (or even individuals) that deploy long-range planning, heavily use
the life cycle costing. It helps them to maximize their long-term profits.
A business that does not consider LCC as important may likely buy assets at a
lower cost. They, however, ignore the costs that they may have to incur during
the asset's useful lives.
LCC helps in choosing from various project alternatives; or various decision
alternatives with regard to acquiring any item for the industry.
Even the customers use LCC concept while purchasing house, cars, white
goods etc.

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Thanks