# CE2451 Engineering Economics & Cost Analysis. Objectives of this course

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1 CE2451 Engineering Economics & Cost Analysis Dr. M. Selvakumar Associate Professor Department of Civil Engineering Sri Venkateswara College of Engineering Objectives of this course The main objective of this course is to make the Civil Engineering student know about the basic law of economics, how to organize a business, the financial aspects related to business, different methods of appraisal of projects and pricing techniques. At the end of this course the student shall have the knowledge of how to start a construction business, how to get finances, how to account, how to price and bid and how to assess the health of a project. 2 1

2 Unit 2: Cost and Break Even Analysis Types of costing traditional costing approach - activity base costing - Fixed Cost variable cost marginal cost cost output relationship in the short run and in long run pricing practice full cost pricing marginal cost pricing going rate pricing bid pricing pricing for a rate of return appraising project profitability internal rate of return pay back period net present value cost benefit analysis feasibility reports appraisal process technical feasibility economic feasibility financial feasibility. Break even analysis - basic assumptions break even chart managerial uses of break even analysis. 3 Cost and Break Even Analysis Unit 5 2

3 Types of Costing Costing - Definition System of computing cost of production or of running a business, by allocating expenditure to various stages of production or to different operations of a firm. 6 3

4 Types of Costing There are different types are used in cost accounting. Different types is used in different industries to analyse and presenting for the purpose of managerial decisions. 7 Types of Costing Marginal costing Absorption costing Standard costing Historical costing 8 4

5 MARGINAL COSTING 9 Marginal Costing In economics and finance, marginal cost is the change in the total cost that arises when the quantity produced has an increment by unit. 10 5

6 Marginal Costing [MC] Curve 11 Marginal Costing That is, it is the cost of producing one more unit of a good or commodity. 12 6

7 Marginal Costing For example, suppose it costs Rs.1000 to produce 100 units and Rs.1020 to produce 101 units. The MC of the 101 st unit is Rs Uses of MC To determine the optimum selling price where company can achieve expected profit. 14 7

8 Uses of MC cont To check the effect of reducing of current price on profit. 15 Uses of MC cont Choose of good product mix, for company producing more than one product. 16 8

9 ABSORPTION COSTING 17 Absorption Costing Absorption costing means that all of the manufacturing costs are absorbed by the units produced. 18 9

10 Absorption Costing In other words, the cost of a finished unit in inventory will include direct materials, direct labor, and both variable and fixed manufacturing overhead. 19 Absorption Costing As a result, absorption costing is also referred to as full costing or the full absorption method

11 Absorption Costing Absorption costing is often contrasted with variable costing or direct costing

12 Absorption Costing Under variable or direct costing, the fixed manufacturing overhead costs are not allocated or assigned to (not absorbed by) the products manufactured. 23 Absorption Costing Variable costing is often useful for management's decision-making. However, absorption costing is required for external financial reporting and for income tax reporting

13 STANDARD COSTING 25 Standard Costing Standard costs are usually associated with a manufacturing company's costs of direct material, direct labour, and manufacturing overhead

14 Standard Costing Rather than assigning the actual costs of direct material, direct labour, and manufacturing overhead to a product, many manufacturers assign the expected or standard cost. 27 Standard Costing This means that a manufacturer's inventories and cost of goods sold will begin with amounts reflecting the standard costs, not the actual costs, of a product

15 Standard Costing As a result there are almost always differences between the actual costs and the standard costs, and those differences are known as variances. 29 Standard Costing If actual costs are greater than standard costs the variance is unfavorable. An unfavorable variance tells management that if everything else stays constant the company's actual profit will be less than planned

16 Standard Costing If actual costs are less than standard costs the variance is favorable. A favorable variance tells management that if everything else stays constant the actual profit will likely exceed the planned profit. 31 HISTORICAL COSTING 32 16

17 Historical Costing A measure of value used in accounting in which the price of an asset on the balance sheet is based on its nominal or original cost when acquired by the company. 33 Historical Costing Based on the historical-cost principle most assets held on the balance sheet are to be recorded at the historical cost even if they have significantly changed in value over time

18 Historical Costing For example, say the main headquarters of a company, which includes the land and building, was bought for Rs.100,000 in 1925, and its expected market value today is Rs. 20 million. The asset is still recorded on the balance sheet at Rs.100, How to arrive final cost of a product/ service/ asset? 36 18

19 TRADITIONAL COSTING APPROACH/ CONVENTIONAL APPROACH 37 Traditional Costing Approach The traditional method of cost accounting refers to the allocation of manufacturing overhead costs to the products manufactured

20 Traditional Costing Approach The traditional method assigns or allocates the factory's indirect costs to the items manufactured on the basis of volume such as the number of units produced, the direct labor hours, or the production machine hours. 39 Traditional Costing Approach By using only machine hours to allocate the manufacturing overhead to products, it is implying that the machine hours are the underlying cause of the factory overhead

21 Traditional Costing Approach Traditionally, that may have been reasonable or at least sufficient for the company's external financial statements. 41 ACTIVITY BASE COSTING (A.B.C) 42 21

22 Activity Base Costing Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method. 43 Activity Base Costing Instead of just one cost driver such as machine hours, ABC will use many cost drivers to allocate a manufacturer's indirect costs

23 Activity Base Costing A few of the cost drivers that would be used under ABC include the number of machine setups, the tones of material purchased or used, the number of engineering change orders, the number of machine hours, and so on. 45 FIXED COST & VARIABLE COST APPROACH 46 23

24 Cost of Production Short-run Total Cost In the short run, one or more (but not all) factors of production (land, labour, machinery and materials) are fixed in quantity. 47 Cost of Production Short-run Total Cost Total Fixed Cost (TFC) refers to total obligation incurred by the firm per unit of time for all fixed inputs. Total Variable Cost (TVC) are the total obligations incurred by the firm per unit of time for all variable inputs it uses

25 Cost of Production Short-run Total Cost i.e. Total Cost equal to TFC + TVC Consider a hypothetical case for different quantities (Q) of production as shown below: 49 Cost of Production Q TFC TVC TC

26 Cost of Production Short-run Total Cost 200 Cost TFC TVC TC Quantity Produced 51 Cost of Production INFERENCE: TFC are constant regardless of the level of output TVC are zero, when the output is zero and rises as output rises 52 26

27 Cost of Production INFERENCE: At every output level, TC equals TFC+TVC. Thus, the TC curve has the same shape as the TVC curve but everywhere above by an amount equal to TFC 53 Cost of Production Short-run Average Cost Average Fixed Costs (AFC) equals to total fixed cost divided by output. Average Variable Cost (AVC) equals total variable costs divided by output

28 Cost of Production Short-run Average Cost Average Cost (AC) equals total cost divided by output. AC also equals AFC+AVC. Marginal Cost (MC) equals the change in TC or change in TVC per unit change in output. 55 Cost of Production Q TFC TVC TC AFC AVC AC MC

29 Cost of Production Typical Cost Curve for Production 100 Cost AFC AVC AC MC Quantity Produced 57 Cost of Production Marginal Cost (MC) Cost Quantity Produced 58 29

30 Cost of Production Note MC schedules are plotted halfway between successive levels of output 59 Cost of Production While AFC curve falls continuously as output is expanded, the AVC, the AC and MC curves are U- shaped. The MC curve reaches the lowest point at a lower level of output than either the AVC or AC curve 60 30

31 Cost of Production The portion of MC intersects the AVC and AC at their lowest points. This is so because whenever extra or marginal amount added to total cost (or variable cost) is less than the average of that cost, the curve necessarily falls. 61 Cost of Production Conversely, whenever the marginal amount added to TC (or TVC) is greater than the average of TC, the average cost rises

32 Cost of Production AVC = AC AFC When MC < AC MC = AC MC > AC AC curve fall continuously Minimum AC AC starts rising 63 Long Run Cost Long-run is the time period long enough for a firm to be able to vary the quantity used of all inputs. Thus, in the long-run, there are no fixed factor and hence no fixed cost and the firm can build any size or scale of plant

33 Long Run Cost The Long-run Average Cost (LAC) curve shows the minimum per unit of cost of producing each level of output when any defined scale of plant can be built. 65 Long Run Cost LAC is given by a curve tangential to all the shortrun average cost (SAC) curves representing all the alternative plant sizes that the firm could built in the long-run

34 25.0 Average Cost SAC-1 SAC-2 SAC-3 SAC Quantity 67 Long Run Cost If the firm expected to produce 2 units of output per unit of time it would built the scale of plant given by SAC-1 and operate it at point A where AC is

35 Long Run Cost we could have drawn many more SAC curves in the figure one for each alternative scales of plant that the firm could built in the long run. By then drawing a tangent to all these SAC curves, we could get the LAC curve. 69 Shape of Curve While the SAC curve and the LAC curve have been drawn as U-shaped, the reason for their shapes is quite different

36 Shape of Curve The SAC curves decline at first, but eventually rise because of the LAW of Diminishing Marginal Returns (resulting from the existence of fixed inputs in the short-run) 71 FULL COST PRICING 72 36

37 Full Cost Pricing It is a price-setting method in which you add: direct material cost + direct labor cost + selling cost + administrative costs + overhead costs + markup percentage (profit) in order to derive the price of the product. 73 Full Cost Pricing This method is most commonly used in situations where products and services are provided based on the specific requirements of the customer

38 Advantages Full Cost Pricing It is simple Likely to get profit Justifiable 75 MARGINAL COST PRICING 76 38

39 Marginal Cost Pricing Marginal cost pricing is the practice of setting the price of a product at or slightly above the variable cost to produce it. 77 Marginal Cost Pricing This situation usually arises in one of two circumstances: A company has a small amount of remaining unused production capacity available that it wishes to use; or A company is unable to sell at a higher price 78 39

40 Marginal Cost Pricing The first scenario is one in which a company is more likely to be financially healthy - it simply wishes to maximize its profitability with a few more unit sales. 79 Marginal Cost Pricing The second scenario is one of desperation, where a company can achieve sales by no other means

41 GOING RATE PRICING 81 Going Rate Pricing Setting a price for a product or service using the prevailing market price as a basis

42 Going Rate Pricing Going rate pricing is a common practice with homogeneous products with very little variation from one producer to another, such as aluminum or steel. 83 BID PRICING 84 42

43 Bid Pricing Price offered by bidder (contractor, supplier, vendor) for a specific good, job, or service, and valid only for the specified period. 85 PRICING FOR A RATE OF RETURN 86 43

44 Pricing for a Rate of Return Rate of return pricing is practiced by businesses that set specific goals for the capital that they spend and the revenue they wish to generate. 87 Pricing for a Rate of Return A business can set prices to ensure that these goals will be achieved

45 Pricing for a Rate of Return This method of pricing is most effectively achieved when a company has little or no competition in the market, since the actions of competitors will likely affect the rate of return (monopolistic). 89 APPRAISING PROJECT PROFITABILITY 90 45

46 Appraising Project Profitability Project appraisal is the process of assessing and questioning proposals before resources are committed. 91 Appraising Project Profitability Project appraisal is the process of assessing and questioning proposals before resources are committed

47 Appraising Project Profitability Project appraisal helps project initiators and designers to; Be consistent and objective in choosing projects Make sure their program benefits all sections of the community, including those from ethnic 93 groups who have been left out in the past Appraising Project Profitability Project appraisal helps project initiators and designers to; Provide documentation to meet financial and audit requirements and to explain decisions to local people

48 INTERNAL RATE OF RETURN 95 Internal Rate of Return IRR calculations are commonly used to evaluate the desirability of investments or projects. The higher a project's IRR, the more desirable it is to undertake the project. Assuming all projects require the same amount of up-front investment, the project with the highest IRR would be considered the best and undertaken first

49 Internal Rate of Return Given a collection of pairs (time, cash flow) involved in a project, the internal rate of return follows from the net present value as a function of the rate of return. A rate of return for which this function is zero is an internal rate of return. 97 Internal Rate of Return where, NPV - Net Present Value C n - Cash flow at time n r - rate of return n - time period, years 98 49

50 Internal Rate of Return Year (n) Cash Flow, Cn NPV (1 r) (1 r) (1 r) 3 r 5.96% 0 99 PAY BACK PERIOD

51 Pay Pack Period Payback period in capital budgeting refers to the period of time required to recoup the funds expended in an investment, or to reach the breakeven point. 101 Pay Pack Period For example, a Rs.1000 investment which returned Rs. 500 per year would have a two-year payback period. The time value of money is not taken into account

52 COST-BENEFIT ANALYSIS 103 Cost-Benefit Analysis Broadly, CBA has two purposes: 1. To determine if it is a sound investment/decision (justification/feasibility) 2. To provide a basis for comparing projects. It involves comparing the total expected cost of each option against the total expected benefits, to see whether the benefits 104 outweigh the costs, and by how much. 52

53 Cost-Benefit Analysis The CBA is also defined as a systematic process for calculating and comparing benefits and costs of a project, decision or government policy / project. 105 FEASIBILITY REPORT

54 Feasibility Report The feasibility study is an evaluation and analysis of the potential of a proposed project which is based on extensive investigation and research to support the process of decision making. 107 Feasibility Report A well-designed feasibility study should provide a historical background of the business or project, a description of the product or service, accounting statements, details of the operations and management, marketing research and policies, financial data, legal requirements and tax obligations

55 Feasibility Report Generally, feasibility studies precede technical development and project implementation. 109 BREAK EVEN ANALYSIS

56 Break Even Analysis Number of units that must be sold in order to produce a profit of zero (but will recover all associated costs). In other words, the break-even point is the point at which your product stops costing you money to produce and sell, and starts to generate a profit for your company. 111 Break Even Analysis

57 Break Even Analysis TR TC P X TFC V X P X V X TFC X ( P V ) TFC TFC X ( P V ) TR-Total Revenue; TC-Total Cost; P-Price per unit; X-No. of units; V-Variable Cost; TFC-Total Fixed Cost 113 Break Even Analysis The quantity,, is of interest in its own right, and is called the Unit Contribution Margin (C): it is the marginal profit per unit, or alternatively the portion of each sale that contributes to Fixed Costs. Thus the break-even point can be more simply computed as the point where Total Contribution = Total Fixed Cost

58 THE END

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