Binghamton University Thomas J Watson School of Engineering

Binghamton University Thomas J. Watson School of Engineering and Applied Science State University of New York

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ISE 211 Engineering Economy Engineering Costs (Chapter 2)

Engineering Costs (CHAPTER II) q Evaluating a set of feasible alternatives requires that many costs analyzed. q Examples: initial investment, new construction, facility modification, general labor, parts and material, inspection and quality, material handling, overhead costs. q Classification of costs: q Fixed, Variable, Marginal, and Average costs q Sunk costs q Opportunity costs q Recurring and Non-recurring costs q Incremental costs q Cash costs Vs. Book costs q Life-cycle costs

Fixed, Variable, Marginal, and Average costs q Fixed costs: constant (unchanging) regardless of the level of output or activity. q Variable costs: depend on the level of output or activity. q Marginal cost: the variable cost for one or more unit. q Average cost: total cost divided by the number of units. q Example: A production environment q fixed costs: q variable costs:

Example 1 q Let’s say: q Fixed cost is $50, variable cost is $1 per unit q If we make 10 units: q Total cost is $60 q Average cost is total cost/number of units: q$60/10=$6 per unit q Marginal cost is the extra cost if we increase our production by 1 unit: $1 per unit

Example 2 An entrepreneur named DK was considering the money-making potential of chartering a bus to take people from his hometown to an event in a larger city. DK planned to provide transportation, tickets to the event, and refreshments on the bus for those who signed up. He gathered data and categorized these expenses as either fixed or variable: DK’s fixed costs Bus rental $80 Event ticket $12. 5/person Gas expense $75 Refreshments $7. 5/person Other fuels Bus driver $20 $50 DK’s variable costs Develop an expression of DK’s total fixed cost, total variable cost, and total revenue for chartering this trip.

Example 2 Solution

Example 2 (cont’d…) Figure 1: Fixed, variable, and total costs

Example 2 (cont’d…) Figure 2: Profit-loss breakeven chart

Sunk Costs q A sunk cost is money already spent due to past decisions. q Sunk costs should be disregarded in engineering economic analysis – current decisions cannot change the past. q Example: money spent last year to purchase new production machinery. q Why is sunk cost always irrelevant? q Decisions between alternatives should be made on the basis of their differences q All identical factors can be canceled out q Sunk costs have already been spent: q Will be the same regardless of what you do q Can be ignored in making that decision

Sunk Costs (cont’d…) q How should you take sunk cost into account? q To learn why it went wrong for future decisions q Example: q You should ignore sunk costs in deciding whether to finish a half-completed project q Study them to learn: q Why your project went wrong q How to avoid similar problems in the future

Opportunity costs q An opportunity cost is cost incurred by choosing to do one thing with your resources instead of doing another. q Examples: q Say a person wants to go to Mexico for Spring Break, taking one week off from their part time job. By doing so, it costs them the cost of the trip plus the lost wages. q The assembly line at a manufacturing facility could be used to produce product B, and the parking lot could be rented out, or used as a building site, etc, which will provide benefits to the company.

Example A distributor of electric pumps must decide what to do with a “lot” of electric pumps that was purchased 3 years ago. Sooner after distributor purchased the lot, technology advances were made, which made the pumps less desirable to customers. The pumps are becoming more obsolescent as they sit in inventory. The pricing manager has the following information: Distributor’s purchase price 3 years ago $7, 000 Distributor’s storage costs to-date 1, 000 Distributor’s list price 3 years ago 9, 500 Current list price of a “lot” of new-pumps 12, 000 Amount offered for the old pumps from a buyer 2 years ago 5, 000 Current price that the lot of old pumps it could be sold for 3, 000 What would be your advice on the price?

Recurring and Non-Recurring Costs q Recurring costs refer to any expense that is known, anticipated, and occurs at regular intervals. Examples: rent, car payment, regular payment, etc. q Non-Recurring costs are one-of-a-kind and occur at irregular intervals -- difficult to plan for or anticipate from a budgeting perspective. q Examples: replacing equipment, ending/starting production of a product, emergency maintenance expense, etc. q Anticipated costs, whether recurring or non-recurring costs can be modeled / handled easily in engineering economic analysis, as cash flows that occur at regular or irregular intervals (e. g. , every year or every five years).

Incremental Costs q Differences in costs between two alternatives – how much more or less does one cost than the other. q Example: Philip is choosing between model A (a budget model) 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? Cost Items Model A Model B Purchase price $10, 000 $17, 500 Installation costs 3, 500 5, 000 Annual maintenance costs 2, 500 750 Annual utility expenses 1, 200 2, 000 Disposal costs after useful life 700 500

Cash Costs Vs. Book Costs q A Cash cost requires the cash transaction of dollars “out of person’s pocket” into the “pocket of someone’s else”. q Cash costs and cash flows are the basis of engineering economics. q Book costs are cost effects from past decisions that are recorded “in the books” (accounting books) of a firm – they do not require transaction of dollars. q Book costs do not ordinarily represent cash flows and thus are not included in engineering economics. q Exception: the impact of asset depreciation on tax payments – which are cash flows included in after-tax analyses.

Life-cycle Costs § Life-cycle costs refers to the costs associated with the various phases of a product/goods/services life cycle. Typical life-cycle of products, goods, and services.

Cumulative life-cycle costs committed and dollars spent

Life-cycle design change costs and ease of change

Cost Estimating q We cannot always know exact costs ahead of time – need to estimate. q Different methods will lead to different estimates – uncertainty. Types of Estimates 1) Rough estimates q The accuracy of rough estimates for initial values/feasibility is -30% to +60% -- humans tend to be optimistic. 2) Semi-detailed estimates q Used for budgeting purposes at the preliminary design stage q -15% to +20%.

Cost Estimating (cont’d) 3) Detailed estimates q Used for detailed design and contract bidding phases q Based on detailed quantitative models: blueprints, vendor quotes, product specification sheet, etc. q -3% to +5% accurate. q Cost more to develop b/c they take more to develop.

Cost Estimating (cont’d) q Why is estimation difficult? q One-of-a-kind projects -- Space station, Hoover Dam q Time and effort available -- the more detail needed, the more time and effort required. q Estimator experience – the more you estimate and then see how the true values come out, the better you become. q How to build experience without estimating things wrongly? q Mentors q Auditing past experience q Starting on small projects q Review meetings

Estimating Models 1. Per Unit Model q Uses a “per unit” factor, times the number of units to determine the total costs. q Simple – provides rough estimates. q Ignores economies of scale (higher quantities cost less on a per unit basis q Used often in the construction industry.

Example Use the per unit model to estimate the cost per student that you will incur for hosting 24 foreign exchange students at a local island campground for 10 days. During camp you are planning the following activities: § 2 days of canoeing § 3 days hiking § 3 days at the lake beach § Nightly entertainment After calling the campground and collecting other information you have accumulated the following data: § Van rental (per person, one way, and plus gas): $50/15 person van § Camp is 50 miles away, van gets 10 mpg, and gas is $1 per gallon § Cabins at the camp hold 4 campers, rent is$10 per day per cabin § Meals are $10 per day per camper (no outside food is allowed) § Boat transportation to the island is $2 per camper (one way) § Insurance/grounds fee/overhead is $1 per day per camper § Canoe rental are $5 per day per canoe (canoes hold 3 campers) § Day hikes $2. 5 per camper (plus cost of meals) § Beach rental is $25 per group per ½ day. § Nightly entertainment is free!

Estimating Models (cont’d) 2. Segmenting Model § Described as “divide and conquer”. § Was used in previous example to break total estimates into smaller and smaller pieces: travel, living, etc. 3. Cost Indexes § Numerical values that reflect historical change in engineering costs (and others). § Dimensionless, and reflect relative price change in either individual items (labor, material, etc) or group/aggregated of costs (consumer and producer prices). Cost at time A Index Value at time A Cost at time B Index Value at time B

Example Miriam is interested in estimating the annual labor and material costs for a new production facility. She was able to obtain the following labor and material cost data: Labor Costs: § Labor Cost Index values at 124 ten years ago and is 188 today § Annual labor costs for a similar facility were $575, 500 ten years ago Material Costs: § Material Cost Index values at 544 three years ago and is 715 today § Annual Material costs for a similar facility were $2, 455, 000 three years ago