Engineering Costs

Chapter 2
Supplemental Reading, Chapter 1
Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000 – Engineering Economics

© Farhoud Delijani, 2023
Learning Objectives

• Define various cost types

• Define various benefit types
• Understand importance of engineering cost types
• Draw cash flow diagrams to show project costs and
benefits
Economic Costs

Costs are analyzed to evaluate alternatives.

• Fixed Costs: Constant unchanging costs
• Variable Costs: Depend on the level of output or activity
• Marginal Costs: Variable cost for one more unit
• Average Costs: Total cost divided by the number of
units
• Total cost: Includes all the different costs
Economic Benefits

Benefits (or Profit) are analyzed to evaluate alternatives

(e.g. using B/C ratio)
• Benefit due to revenue
• Benefit due to ‘salvage value’ of assets
• Benefit due to improved efficiency (cost reductions)
• Other benefits (loans, awards, property value, brand,
risk reduction/insurance, productivity,...)
Fixed, Variable and Total Costs
Marginal cost changing
to $300 after 10 units

Marginal Cost

$3,000

12

• Total Cost = total fixed cost + total variable cost

Example 1
Problem:
An entrepreneur named DK is considering chartering a bus to
take a group of people to an event in a larger city. DK plans to
provide transportation, tickets to the event, and refreshments
on the bus. He gathered and categorized the predicted
expenses as follows:

Assume DK charges $35 per person, determine DK’s total

profit if 30 people take the bus to go to the event.
Example 1
Solution:
DK’s fixed costs will be incurred regardless of how many people sign up
for the trip.

DK’s variable costs depend on how many people sign up for the charter:

DK’s total cost:

Example 1
Solution:

DK’s total revenue:

DK’s total profit:

Ticket Price Total Cost
 Profit-Loss Break-Even Chart
Break-even point can be used to create profit-loss break-even chart
• Breakeven point: total costs = total revenue
• Profit region: total revenue > total costs
• Loss region: total costs > total revenue
Other Types of Costs

• Sunk costs
• Opportunity costs
• Recurring costs
• Non-recurring costs
• Incremental costs
• ‘Cash costs’ versus ‘book costs’
Sunk Costs

• Money already spent due to a past decision

• Should be disregarded in engineering economic
analysis
• Nothing can be done at this point to change the cost
Opportunity Costs

• The costs associated with a resource being used for an

alternate task
• Sometimes referred to as “forgone opportunity costs”
• “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
a forgone activity.”
Recurring and Non-Recurring Costs

• Recurring Cost: A cost that reoccurs at regular intervals

• Non-recurring Cost: One-of-a-kind cost recurring at
irregular intervals
Incremental Costs

• Incremental Cost: Cost differences between

alternatives (See Example 3)
Cash Costs versus Book Costs

• Cash costs require a cash transaction (cash flow)

• Book costs are recorded but are not transactions
• Do not represent cash flows, thus are not included in
engineering economic analysis
Example 2
A distributor of electric pumps must decide what to do with
a batch of old electric pumps purchased three years ago.
Soon after the distributor purchased the lot, technology
advances made the old pumps obsolete. The pricing
manager has the following information:

Distributor’s purchase price three years ago $7,000

Distributor’s storage costs to date 1,000
Distributor’s list price three years ago 9,500
Current list price of the same number of new advanced pumps 12,000
Amount offered for the old pumps from a buyer two years ago 5,000
Current price the batch of old pumps would bring 3,000
Example 2 Distributor’s purchase price three years ago

Distributor’s storage costs to date

$7,000

1,000
Distributor’s list price three years ago 9,500

Current list price of the same number of new advanced pumps 12,000

Amount offered for the old pumps from a buyer two years ago 5,000

Current price the batch of old pumps would bring 3,000

Looking at the data, the pricing manager concludes that the price the
old lot should be sold at is $8,000:

• This is the money the firm has spent on the lot ($7,000 purchase and
$1,000 storage), so the company should recover this cost at least.

• This would also be $1,500 less than the list price from three years
ago ($9,500), and it would be $4,000 less what a lot of new pumps
would cost ($12,000).

What would be your advice on price?

Solution
• Distributor’s purchase price three years ago: This is a sunk cost that
should not be considered in setting the price today.
• Distributor’s storage costs to date: The storage costs for keeping the
pumps in inventory are sunk costs; that is, they have been paid. Hence
they should not influence the pricing decision.
• Distributor’s list price three years ago: If there have been no willing
buyers in the past three years at this price, it is unlikely that a buyer will
emerge in the future. This past list price should have no influence on
the current pricing decision.
• Current list price of newer pumps: Newer pumps now include
technology and features that have made the older pumps less valuable.
It is misleading to compare the older pumps directly to those with new
technology. However, the price of the new pumps and the value of the
new features help determine the market value of the old pumps.
Solution
• Amount offered by a buyer two years ago: This is a forgone
opportunity. At the time of the offer, the company chose to keep the lot,
and thus the $5,000 offered became an opportunity cost for keeping
the pumps. This amount should not influence the current pricing
decision.
• Current price the lot could bring: The price a willing buyer in the
marketplace offers is called the asset’s market value. The lot of old
pumps in question is believed to have a current market value of $3,000.
➢ From this analysis, it is easy to see the flaw in the pricing manager’s
reasoning. In an engineering economic analysis we deal only with
today’s and prospective future opportunities. It is impossible to go
back in time and change decisions that have been made. Thus the
pricing manager should recommend to the distributor that the price be
set at the current value that a buyer assigns to the item: $3,000.
Example 3
Philip is choosing between model A and model B (with
more features and a higher purchase price). What
incremental costs would Philip incur if he chose model B
instead of the less expensive model A?
Solution
• We are interested in the incremental or extra costs that result from choosing model
B instead of model A. To obtain these we subtract model A costs from model B
costs for each category (cost item) with the following results:

• Notice that for the cost categories given, the incremental costs of model B are both
positive and negative:
• Positive incremental costs mean that model B costs more than model A
• Negative incremental costs mean that there would be a saving (reduction in
cost) if model B were chosen instead.
Solution

• Because model B has more features, a decision would also

have to take into account the incremental benefits offered by
that model.
Life-Cycle Costs

• Goods and services are designed and progress through

a life-cycle.
• Life-cycle costing considers the costs over the entire
life-cycle
Two key concepts in design of goods:
1. The later a design change is made, the higher the
cost
2. Right decisions made early in the life cycle, tend to
“lock in” costs that will be incurred later
Typical Life Cycle for Products, Goods
and Services
Cumulative Life-Cycle Costs ‘Committed’
and ‘Dollars Spent’
Life-Cycle ‘Design Change Costs’ and ‘Ease
of Change’
Cash Flow Diagrams
Cash Flow Diagrams
Cash Flow Diagrams

• Categories of cash flows

➢First cost
➢Operations and maintenance
➢Salvage value
➢Revenues
➢Overhaul
Example 4

Problem:
A manager has decided to purchase a new $30,000
mixing machine. The machine may be paid for in one of
two ways:
1. Pay the full price now minus a 3% discount.
2. Pay $5,000 now; at the end of one year, pay $8,000; at the
end of each of the next four years, pay $6,000.

List the alternatives in the form of a cash flow table and

a cash flow diagram.
 Example 4
Solution:
1. Pay the full price now minus a 3% discount.
2. Pay $5,000 now; at the end of one year, pay $8,000; at the end of
each of the next four years, pay $6,000.
 Example 4
Solution:
1. Pay the full price now minus a 3% discount.
2. Pay $5,000 now; at the end of one year, pay $8,000; at the end of
each of the next four years, pay $6,000.
 Example 5
Problem:

Draw the following cash flow diagram for the following car purchase scenario:
➢ Total lifetime is 10 years (that’s how long you want to keep the car)
➢ You pay $8500 down payment today
➢ You pay $600 per year for the next 10 years for financing costs
➢ At year 5, you pay $2200 for tire replacement
➢ You receive $1000 mileage money from your work at years 3 and 7
➢ You receive $1300 in form of salvage value at year 10 once you sell the car
 Engineering Costs
Chapter 2
Supplemental Reading, Chapter 1
Newnan, D., Whittaker, J., Eschenbach, T., and Lavelle, J. (2018). Engineering Economic
Analysis (4th Canadian edition). Oxford University Press.

ENG 3000 – Engineering Economics

© Farhoud Delijani, 2023