Engineerin Economics Chapter (Eng. Eco) 006

7/29/2019 Engineerin Economics Chapter (Eng. Eco) 006

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By

Muhammad Shahid Iqbal

Module No. 06

Theory of Cost

Engineering

Economics


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The Concepts of cost

Should I go to work today? Should I go to college after highschool? Should the government spend money on a new weaponsystem? These are decisions that are made everyday; however,what is the cost of our decisions? What is the cost of going towork, or the decision not to go to work? What is the cost ofUniversity, or not to go to University? Finally what is the cost of

buying that weapon system, or the cost of not buying thatweapon? In economics it is called opportunity cost.

Opportunity cost is the cost we pay when we give up somethingto get something else. There can be many alternatives that we

give up to get something else, but the opportunity cost of adecision is the most desirable alternative we give up to get whatwe want.

Opportunity cost of an input is the return that it could earn in itsbest alternative use.


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Accounting Costs and Economic Costs

A firms cost of production includes all the opportunity costsof making its output of goods and services.

Explicit and Implicit Costs

A firms cost of production include explicit costs and implicitcosts.

Explicit costs: All cash payments which the firm makes toother factor owners for purchasing or hiring the various

factors.


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Implicit costs: The normal return on money-capital invested by the entrepreneur andwages or salary of his services and moneyrewards for other factors which the

entrepreneur himself owns and employs themin his own firm.

Economic Cost= Accounting costs + Implicit costs


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Economic Profit v/s Accounting Profit

Economists measure a firms economic profitas totalrevenue minus total cost, including both explicit andimplicit costs.

Accountants measure the accounting profitas the firms

total revenue minus only the firms explicit costs. When total revenue exceeds both explicit and implicit

costs, the firm earns economicprofit.

Economic profit is smaller than accounting profit


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Total and Variable Costs

The total expenditure put up

by an entrepreneur to

produce a certain amount of

a good is called TC:

C(Q) = FC+ VC

Fixed costs are those costs

that do notvary with thequantity of output produced

Variable costs are those

costs that do vary with the

quantity of output produced

$

Q

C(Q) =VC+FC

VC(Q)

FC


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The elements of cost

Fixed costs or overhead cost can be classified into factory overhead,administration overhead, selling overhead and distribution overhead.

Variable costs can be further classified into direct material, directlabor and direct expenses.

The selling price is derived as shown below

a) Direct material cost + Dir. labor cost + Direct expenses = Prime cost

b) Prime cost + Factory overhead = factory cost

c) Factory cost + office and administrative overhead = cost of production

d) Cost of production + opening finished stockClosing finished stock= cost of goods sold

e) cost of goods sold + selling and distribution overhead = cost of salesf) cost of sales + profit Sales

g) Sales/quantity sold selling price per unit


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Sunk Cost: A cost that is forever lost after it has been paid.

ACME Coal paid $5000 to lease a rail car. Under the terms of

the lease $1000 of this payment is refundable if the rail car is

returned within two days of signing the lease.

Average cost: average cost orunit cost is equal to total costdivided by the number of goods produced (the output quantity,

Q). It is also equal to the sum of average variable costs (total

variable costs divided by Q) plus average fixed costs (total

fixed costs divided by Q).



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Marginal Cost: The marginal cost of a product is the cost of

producing an additional unit of that output. More formally, the

marginal cost is the derivative of total production costs with respect to

the level of output.

Marginal Revenue (MR) is the extra revenue that an additional unit ofproduct will bring. It is the additional income from selling one more

unit of a good; sometimes equal to price. It can also be described as the

change in total revenue divided by the change in the number of units

sold. i.e. Q= 40,000 2000P

Marginal cost and average cost can differ greatly. For example,

suppose it costs $1000 to produce 100 units and $1020 to produce 101

units. The average cost per unit is $10, but the marginal cost of the

101st unit is $20



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Break Even Analysis

Break-even point (BEP) isthe point at which cost orexpenses and revenue areequal: there is no net loss orgain. The main objective of

break-even analysis is tofind the cut-off productionvolume from where a firmwill make profit.

X = TFC/P-V

X = TFC/Unit Contribution Contribution = SalesTVC

Margin of Safety = SalesBreak Even sales


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Profit Volume Ratio (P/V Ratio), The ratio ofcontribution to sales is P/V ratio or C/S ratio. It is thecontribution per rupee of sales and since the fixed costremains constant in short term period, P/V ratio will also

measure the rate of change of profit due to change involume of sales.

The P/V ratio may be expressed as follows:

Profit = ContributionFixed cost

P/V ratio = SalesVariable costs = ContributionSales Sales

BEP = Profit

P/V ratio

Break Even Analysis


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Some Definitions

Average Total CostATC = AVC + AFCATC = C(Q)/Q

Average VariableCost

AVC = VC(Q)/QAverage Fixed Cost

AFC = FC/Q

Marginal CostMC = DC/DQ

$

Q

ATC

AVC

AFC

MC


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Derivation of Average costs

Q FC VC TC AFC AVC ATC MC

0 2000 0 2000 --- ---

76 2000 400 2400 26.32 5.26 31.58 5.26

248 2000 800 2800 8.06 3.23 11.29 2.33

492 2000 1200 3200 4.07 2.44 6.51 1.64784 2000 1600 3600 2.55 2.04 4.59 1.37

1100 2000 2000 4000 1.82 1.82 3.64 1.27

1416 2000 2400 4400 1.41 1.69 3.10 1.27

1708 2000 2800 4800 1.17 1.64 2.81 1.37

1952 2000 3200 5200 1.02 1.64 2.66 1.64

2124 2000 3600 5600 0.94 1.69 2.63 2.33

2200 2000 4000 6000 0.91 1.82 2.73 5.26


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Relationship b/w Average & Marginal Cost

whenever MC is below AC curve,the average curve is falling.The low MC Drags down theAverage.

when MC is above AC curve, itpull the average up; the ACcurve rises.

When MC equal AC, it has aneutral effect. AC curve is flat.It has reached its lowest point.Thus MC curve cuts throughthe lowest point on the ATCcurve. MC also cuts AVCthrough its lowest point.

AVC


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LR Cost Functions: Economies of Scale

Economies of scale arise when the cost per unit falls as output

increases. Economies of scale are the main advantage of

increasing the scale of production

Bulk-buying economies

Technical economies

Financial economies

Marketing economies

Managerial economies

lower unit costs as a result of the whole industry growing insize.

Training and education becomes more focused on the industry

Other industries grow to support this industry

Engineerin Economics Chapter (Eng. Eco) 006

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