Engineering Economic

Hamad Manzoor
 Chapter 8
Cost Concepts Relevant to
Decision Making
Chan S. Park
Topics to Cover
• General Cost Terms

• Classifying Costs for Financial Statements

• Thinking on the Margin: Fundamental Economic

Decision-Making

• Cost Classification for Predicting Cost Behaviors

3
An Example
• We will start with an example to understand the
concepts covered in this chapter
• The example is of a ice-cream producer producing
ice-cream cones

“Uptown Ice Cream Shop”

4
Unit Price of an Ice Cream Cone: Uptown Ice Cream
Shop

120250 / 0.65 =
Or
9250/ 0.05 =
Or …
185000 Cones

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General Cost Terms

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General Cost Terms
• Manufacturing Costs
Direct materials
Direct labor
Mfg. Overhead include
Indirect materials, indirect labor; maintenance and
Repairs on production equipment; heat and light;
property taxes; depreciation; insurance, etc.,

• Non-manufacturing Costs
Overhead
Heat and light, property taxes, depreciation
Marketing or selling
Advertising, shipping, sales travel, sales salaries
Administrative
Executive compensation, general accounting,
Public relations, and secretarial support.

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 Classifying Costs for Financial Statements
• In financial accounting, the Matching
Concept states that the costs
incurred to generate particular
revenue should be recognized as
expenses in the same period that the
revenue is recognized.
• Period costs: Those costs that are
charged to expenses in the time
period basis (advertising, executive salaries, sales
commissions, public relations, other non manufacturing
costs).
• Product costs:Those costs that are
involved in the purchase or
manufacturing of goods. Since
product costs are assigned to
inventories, known as inventory
costs. (all costs related to manufacturing process).
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 Classifying Costs for Uptown Ice Cream Shop

Product
Cost

Period Cost

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Cost Flows and Classifications in a Mfg. Co.

Cost of revenue =
Cost of goods sold

• Raw materials
inventory
• Work-in-process
inventory
• Finished goods
inventory

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 Cost Classification for Predicting Cost Behavior
• Volume index

Operating cost respond in some way to changes in its operating volume.

Need to determine some measurable volume or activity which has strong Influence on the
amount of cost incurred. (volume index may be based on production inputs/out puts. Energy
consumption, labor hours OR KWhr generated or miles per year driven by a car)

• Cost Behaviors
Fixed costs
Variable costs
Mixed costs

In the car case, Depreciation, occur from passage of time (fixed portion) and also
More miles are driven a year, loses its Market value (variable portion)
• Average unit costs

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Volume index:
• It is necessary to distinguish between changes arising solely from
price changes and those arising from other influences such as
quantity and quality, which are referred to as changes in
“volume”.

• A volume index is presented as a weighted average of the

proportionate changes in the quantities of a specified set of
goods or services between two periods of time.

• The quantities compared must be homogeneous, while the

changes for different goods and services must be weighted by
their economic importance as measured by their values in one or
other, or both, periods.

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Volume index: (Illustrated Example)
• Consider an industry that produces two different models of automobile, one selling for twice
the price of the other.
• From an economic point of view these are two quite different products even though described
by the same generic term "automobile". Suppose that between two periods of time:
• (a) The price of each model remains constant; (b) The total number of automobiles
produced remains constant; (c) The proportion of higher priced models produced increases
from 50 % to 80 %
• .It follows that:
• the total value of the output produced increases by 20 % because of the increase in the proportion
of higher-priced models. This constitutes a volume increase of 20 %. As each higher-priced
automobile constitutes twice as much output as each lower-priced automobile, a switch in
production from low- to high-priced models increases the volume of output even though the total
number of automobiles produced remains unchanged. The fact that the value increase is entirely
attributable to an increase in volume also follows from the fact that no price change occurs for
either model. The price index must remain constant in these circumstances.

• cost cheaper * 50 + cost expansive * 50

• Before: 1 * 50 + 2 * 50 =150 🡪 After: 1* 30 + 2 * 80 = 160+30 = 180
• 180-150/150 * 100 = 20% increase in volume index.
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Fixed Costs or capacity cost

• Definition: The costs of providing a company’s

basic operating capacity
• Cost behavior: Remain constant over the time
though volume may change.
• Some examples; Annual insurance premium,
property tax, and license fee, building rents,
depreciation of buildings, salaries of
administrative and production personnel.

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Variable Costs
• Definition: Costs that vary depending on the level
of production or sales

• Cost behavior: Increase or decrease according to

the level of volume change.

• Example: Ice cream cone company, wages,

payroll taxes, sales tax, and supplies. Fuel
consumption is directly related to miles driven.

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Average Unit Cost
• Definition: activity cost
on a per unit basis

• Cost Behaviors:
• Fixed cost per unit
varies with changes in
volume.
• Variable cost per unit of
volume is constant. See
example 3.2

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Cost Classification of Owning and Operating a Passenger Car

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Cost-Volume Relationship

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Cost-Volume Relationship

.04M
06 4+0
1

$1064

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Average Cost per Mile

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Cost Concepts relevant to the decision making.

• Costs are an important feature of many business

decisions. In order to make such decisions
following cost needed to be well understood…
• Differential costs
• Opportunity costs
• Sunk costs
• Marginal costs

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Differential (Incremental) Costs Revenues

• Decision involve selection among alternatives.

• Each alternative have certain costs / benefits that
are needed to be compared to the costs / benefits
of the other alternatives

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Differential (Incremental) Costs and Revenues

• Definition: Difference in costs between any two

alternatives known as Differential cost.
• Difference in revenues between any two alternatives
is known as differential revenue.

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Differential (Incremental) Costs Revenues

• Cost-volume relationship based on differential

costs find many engineering applications such as
short term decision making. Example:
• The base case is the status quo (current operation).
We propose an alt. to the base case. If alt. has
lower cost we accept the alt. assuming
non-quantitative factors do not offset the cost
advantage.

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Differential (Incremental) Costs Revenues

• Differential cost = difference in total cost that

results from selecting one alt. instead of the other.
• Problem of this type are generally called trade off
problems because one type of cost is traded by
another type of cost
• KEY FEATURES: New investment in physical assest
not required, planning horizon short, relatively few
cost items are subject to change by the decision

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Differential (Incremental) Costs Revenues

• Common examples:
• Method change – Example 3.3 page 75
• Operations planning – Example 3.4 page 76
• Make or buy decision – Example 3.5 page 77

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Example - Differential Cost Associated with Adopting a New Production Method

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 Example - Break-Even Volume Analysis

• Option 1: Adding overtime or

Saturday operations: 36Q
• Option 2: Second-shift operation:
$13,000 + 31.50Q
• Break-even volume:
36Q = $13,000 + 31.50Q
Q = 3,000 units

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 Example -Make or Buy
Many firms perform certain activities using their own resources and pay outside firms to
perform certain other activities.
It is a good policy to constantly seek to improve the balance between these two types of
activities.

(c) 2002 Contemporary Engineering Economics 29

Opportunity Costs
• Definition: The potential benefit that
is given up as you seek an alternative
course of action
• Example: When you decide to pursue
a college degree, your opportunity
cost would include the 4-year’s
potential earnings foregone.

(c) 2002 Contemporary Engineering Economics 30

Sunk Costs
• Definition: Cost that has already been
incurred by past actions
• Economic Implications: Not relevant
to future decisions
• Example: $200 spent to replace
water-pump last year—not relevant
in making selling decision in the
future

(c) 2002 Contemporary Engineering Economics 31

Marginal Analysis

• Principle: “Is it worthwhile?”

• Decision rule: To justify any
course of action,
Marginal revenue >
Marginal cost

(c) 2002 Contemporary Engineering Economics 32

 Marginal Costs

• Definition: Added costs that result

from increasing rates of outputs,
usually by single unit
• Example 3.6: Cost of
electricity—decreasing marginal rate
• Compare it with Differential cost
(Account’s) / Marginal (Economist’s)

(c) 2002 Contemporary Engineering Economics 33

Unit Marginal Contribution (MC)
• Definition: Difference between the
unit sales price and the unit variable
cost, also known as marginal income
or producer’s marginal contribution
(MC). This means each unit sold
contributes toward absorbing the
company’s fixed cost.
MC = U Sales price – U Variable cost
• Application: Break-even volume
analysis:

(c) 2002 Contemporary Engineering Economics 34

Example 3.7 Profit Maximization Problem

(c) 2002 Contemporary Engineering Economics 35

 Summary
• General Cost Terms used in manufacturing:
– Manufacturing costs
• Direct materials
• Direct labor
• Manufacturing overhead
– Nonmanufacturing costs
• Administrative expenses
• Marketing
• Nonmanufacturing overhead

(c) 2002 Contemporary Engineering Economics 36

• Classifying Costs for Financial Statements:
– Period costs
– Product costs

• Cost Classification for Predicating Cost

Behaviors:
– Fixed costs
– Variable costs
– Mixed costs

(c) 2002 Contemporary Engineering Economics 37

• Cost Concepts Relevant to Decision-Making
– Differential cost and revenue
– Opportunity costs
– Sunk costs
– Marginal costs

• Thinking on the Margin: Fundamental Economic

Decision-Making:
– The basic question to any economic decision: Is it
worthwhile?
– Marginal revenues must exceed marginal costs.

(c) 2002 Contemporary Engineering Economics 38