Cost Concepts and

Design Economics
Chapter 2
Cost Terminology
Fixed, Variable & Incremental
Cost
 Fixed costs are the costs that are not affected by the
level of activity over a feasible range of operation.

 Key Characteristics:
i. Do not vary with production or sales volume.
ii. Incurred even if no goods or services are produced.
iii. Associated with the overall operation rather than individual
units of output.
Fixed, Variable & Incremental Cost
Examples of Fixed Costs:
1. Insurance on Facilities
• Example: A factory pays $5,000 per year for fire insurance,

whether it produces 10 or 1,000 products.

2. Taxes on Facilities
• Example: A company pays property tax of $2,000 annually on its

office building, independent of its revenue.

3. General Management and Administrative Salaries
• Example: The CEO of a company earns a fixed salary of

$100,000 per year, regardless of how much the company

produces.
4. License Fees
• Example: A restaurant pays an annual food license fee of $500,

even if it operates at full capacity or remains closed for a few

months.
5. Interest on Borrowed Capital
• Example: A business takes a loan and has to pay a fixed monthly

interest of $1,000, regardless of its sales.

 Fixed, Variable & Incremental Cost
When Do Fixed Costs Change?

1.Major Increase or Decrease in Resource Usage

1. Example: A company renting a small warehouse for $10,000 per year
expands to a larger facility costing $20,000 per year.
2.Plant Expansion
1. Example: A factory builds a new production unit, increasing property taxes
and insurance costs.
3.Shutdown or Downsizing
1. Example: A company shuts down a branch, reducing rent, administrative
salaries, and utility costs.
4.New Regulations or Economic Conditions
1. Example: A rise in interest rates increases loan repayment costs, even if the
loan amount remains the same.

•Key Takeaway: Fixed costs are not absolutely constant—they remain stable
within a specific range but can change when major operational shifts occur.
 Fixed, Variable & Incremental
Cost
Variable costs change in total as the level of production or
business activity changes. However, the cost per unit
remains the same.

Key Characteristics:
1. Directly proportional to production/output.
2. If production increases, total variable costs increase.
3. If production decreases, total variable costs decrease.
4. The cost per unit remains constant.
 Fixed, Variable & Incremental
Cost
Examples of Variable Costs:
1. Raw Materials
1. Example: If a bakery spends $2 per loaf of bread on flour, buying ingredients for
100 loaves costs $200, while for 200 loaves, it costs $400.
2. Direct Labor (Wages paid per unit produced or per hour worked)
1. Example: A factory pays workers $5 per unit produced. If they make 50 units,
labor costs $250, but for 100 units, it becomes $500.
3. Utility Costs (Energy, Water, Gas for Production)
1. Example: A steel factory’s electricity bill increases as more machines operate to
produce more steel.
4. Sales Commissions
1. Example: A salesperson earns a 10% commission per product sold. Selling 10
products earns them $100, but selling 50 earns $500.
5. Shipping/Delivery Costs
1. Example: A company pays $5 per package shipped. If it ships 100 packages, the
cost is $500; for 200 packages, it’s $1,000.
 Fixed, Variable & Incremental
Cost
 Key Takeaway:

• Total variable cost = Cost per unit × Number of

units produced

• The more you produce, the more you pay in variable

costs, but the cost per unit stays the same.
 Fixed, Variable & Incremental
Cost
The additional cost or revenue incurred when increasing
output by one or more units.

Key Characteristics:

1. Helps in "go–no go" decisions (whether to proceed

with an action or not).
2. Depends on various factors like usage, demand, and
capacity.
3. Often difficult to calculate precisely due to changing
conditions.
 Fixed, Variable & Incremental
Cost
Examples of Incremental Cost
1.Pizza Shop 🍕
•A shop makes 10 pizzas for $50.
•Making 11 pizzas increases the cost to $55.
•Incremental cost for 1 extra pizza = $5.
2.Car Travel 🚗
•Driving 100 miles costs $10 in fuel.
•Driving 101 miles costs $10.50.
•Incremental cost for 1 extra mile = $0.50.
3.Factory Production 🏭
•A factory makes 1,000 toys for $5,000.
•Producing 1,100 toys increases costs to $5,500.
•Incremental cost for 100 extra toys = $500 (or $5 per toy).
 Fixed, Variable & Incremental
Cost
 Key Takeaway:

• Incremental cost = Additional cost for additional output.

• Businesses use it to decide if making more products is
profitable.
 Fixed, Variable & Incremental Cost

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 (yd 3-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. Compare the two sites in terms of their fixed,
variable, and total costs. 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?
Fixed, Variable & Incremental Cost
Fixed, Variable & Incremental Cost
Direct, Indirect & Standard
Costs
Costs that can be directly traced to a specific product, service,
or activity.
These costs are easily measurable and allocated to a particular
output.
•Examples:
1. Manufacturing:
•Steel used to make scissors ✂️
•Wood used to make furniture 🪑
2. Construction:
•Cement and bricks for building a house 🏠
•Wages paid to construction workers
3. Service Industry:
•Salary of a software developer working on a specific
project 💻
•Raw ingredients for making pizza in a restaurant 🍕
 Direct, Indirect & Standard

Costs
Costs that cannot be directly traced to a specific product, service,
or activity.
 They are shared costs that benefit multiple products or departments.
 Usually allocated using a formula (e.g., based on labor hours or
material costs).
Examples:
1. Manufacturing:
•Factory rent 🏭 (benefits all products made in the factory)
•Equipment maintenance 🔧 (used for multiple production lines)
2. Construction:
•Supervisor salary (oversees multiple projects)
•Common tools and general supplies (used for various tasks)
3. Service Industry:
•Electricity bill for an office 💡 (shared by all employees and
departments)
•Office supplies like pens and printers ✏️ (used by everyone)
Direct, Indirect & Standard
Costs
 Overhead cost consists of plant operating costs that
are not direct labor or material costs. Examples of
overhead include electricity, general repairs, property
taxes, and supervision.

 indirect costs, overhead and burden are usually used

interchangeably.
 Direct, Indirect & Standard Costs
•Pre-determined costs set before actual production or service
delivery.
•Based on expected labor, materials, and overhead costs per unit.
•Used for budgeting, cost control, and performance evaluation.
•Examples:
1. Manufacturing:
•Expected labor cost per table = ₨ 500 🪑
•Estimated wood cost per table = ₨ 2,000
•Standard cost per table = ₨ 2,500
2. Construction:
•Standard cement cost per house = ₨ 50,000 🏠
•Standard brick cost per house = ₨ 20,000
3. Service Industry:
•Estimated call center labor cost per customer = ₨ 300 ☎️
•Standard fuel cost per taxi ride = ₨ 500 🚖
Cash Cost versus Book Cost
•Cash costs are actual expenses paid in cash during business
operations.
•These costs involve real cash outflows, unlike non-cash costs
(e.g., depreciation).
•Used for financial planning and cash flow management.
•Examples:
•Manufacturing:
•Paying workers' wages in cash 💵
•Purchasing raw materials 🏭
•Construction:
•Buying cement and steel for a project
•Paying contractors and laborers 6
•Service Industry:
•Paying office rent and utility bills 🏢💡
•Buying fuel for company vehicles 🚗
 Cash Cost versus Book Cost
•A cost recorded in financial statements but does not involve actual cash
payment.
•Also called non-cash costs because they do not impact cash flow.
•Used for accounting and tax purposes rather than actual cash transactions.
•Examples:
•Depreciation 🏭
•A company owns a machine worth ₨ 1,000,000. Each year, it loses value
by ₨ 100,000 due to usage. This depreciation is recorded as an expense, but
no cash is spent.
•Imputed Interest 💰
•A business uses its own money instead of taking a loan. The potential
interest income lost is considered a book cost.
•Owner’s Salary in Small Business 🏢
•If a business owner does not take a salary, the estimated salary cost may
still be recorded for financial analysis.
Sunk Costs & Opportunity Cost

•A cost that has already been incurred and cannot be

recovered.
•Irrelevant for future decision-making because it
remains the same regardless of the chosen alternative.
•Should be ignored in financial analysis when
considering future costs and revenues.
Sunk Costs & Opportunity Cost

•Examples of Sunk Costs:

•Buying a Movie Ticket
•You buy a ₨ 1,000 ticket but realize the movie is boring. The money
cannot be refunded, so leaving or staying doesn’t change the cost.
•Non-Refundable Hotel Booking 🏨
•You pay ₨ 10,000 for a hotel, but later find a better option. The ₨
10,000 is lost, so it should not affect your new decision.
•Business Equipment Purchase 🏭
•A factory buys a ₨ 5 million machine, but a better model is released.
The old machine's cost is a sunk cost and should not affect buying a new
one.
•Marketing Expenses 📢
•A company spends ₨ 500,000 on advertising, but sales do not increase.
The money is already spent and should not impact future marketing
plans.
•Passport or Visa Fees 🛂
•If you spend ₨ 20,000 on a passport but decide not to travel, the
money is already spent and should not affect future travel decisions.
Sunk Costs & Opportunity Cost
Sunk Costs & Opportunity Cost
 What is Opportunity Cost?
• The benefit lost when choosing one option over
another.
• It happens when resources (money, time, effort) are
limited, and you give up the next best alternative.
• Often hidden because it’s not recorded like actual
expenses, but it’s important in decision-making.
Sunk Costs & Opportunity Cost
Sunk Costs & Opportunity Cost
Sunk Costs & Opportunity Cost
LIFE-CYCLE COST
 Life-cycle cost is the summation of all costs, both
recurring and nonrecurring, related to a product,
structure, system, or service during its life span.
 Life cycle begins with the identification of the

economic need or want ( the requirement ) and ends

with the retirement and disposal activities.
 LCC are a summation of all the costs (and some

revenues) over the entire life span of a structure, or

system.
LIFE-CYCLE COST
 Recurring costs
 Recurring costs are costs that are repeated when an organization
produces similar goods or services on a continuing basis.
 Examples of recurring costs are variable costs, because they
repeat with each unit of output
 Nonrecurring costs
 Nonrecurring costs are those costs which are not repetitive with
the production of a merchandise or service.

 Examples of recurring costs are purchase cost for real estate
upon which a plant will be built and construction costs.
The General Economic
Environment
Consumer and Producer Goods
and Services
 Consumer goods and services are those
products or services that are directly used
by people to satisfy their wants. Food,
clothing, homes, cars, television sets,
haircuts, opera, and medical services are
examples.
 Producer goods and services are used to

produce consumer goods and services or

other producer goods. Machine tools,
factory buildings are examples.
Measures of Economic
Worth
 Goods and services are produced and
desired because they have utility—the
power to satisfy human wants and needs.

 Utility is most commonly measured in terms

of value(price that must be paid to obtain
the particular item)
Necessities, Luxuries, and Price
Demand
 Goods and services may be divided into two
types:
1. necessities
2. luxuries
 These terms are relative, because, for most

goods and services, what one person

considers a necessity may be considered a
luxury by another.
Necessities, Luxuries, and Price
Demand
Necessities, Luxuries, and Price
Demand
 The relationship between price and
demand can be expressed as the linear
function

 where a is the intercept on the price axis

and −b is the slope.
Competition
 Most general economic principles are stated
for situations in which perfect competition
exists.
 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.
Competition
 Monopoly is at the opposite pole from
perfect competition.

 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.
The Total Revenue
Function

 Maximum total revenue can be obtained by,

The Total Revenue
Function
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
Cost, Volume, and Breakeven
Point Relationships
Cost, Volume, and Breakeven
Point Relationships
Cost, Volume, and Breakeven
Point Relationships
Breakeven Point
 An economic breakeven point for an
operation occurs when total revenue equals
total cost.
Question 2.12
 A company produces circuit boards used to
update outdated computer equipment. The
fixed costs $42,000 per month, and the variable
cost is $53 per circuit board. The selling price
per unit is p=$150−0.02D. Maximum output of
the plant is 4,000 units per month.
 a. Determine optimum demand for this product.
 b. What is the maximum profit per month?
 c. At what volumes does breakeven occur?
 d. What is the company’s range of profitable
demand?
Question
 Anelectric power plant uses solid
waste for fuel in the production of
electricity. The cost Y in dollars per
hour to produce electricity is
Y = 12 + 0.3 X +0.27X^2 ,where X is
in megawatts. Revenue in dollars per
hour from the sale of electricity is15
X − 0.2X^2.Find the value of X that
gives maximum profit.