Engineering Economy Chapter # 02

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COST CONCEPTS AND

DESIGN ECONOMICSChapter # 2


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Objectives

Objectives of Chapter 2 are:

Describe some of the basic cost terminology and concepts encounteredin the book

Illustrate how they should be used in engineering economic analysis anddecision making

Following topics are discussed:

Fixed, variable and incremental costs

Recurring and nonrecurring costs

Direct, indirect and overhead costs

Standard costs

Cash cost versus book cost

Sunk and opportunity costs Life cycle and life cycle costs

General economic environment

Relationship between price and demand, total revenue function

Break even point(s), maximizing profits, present economy studies

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Introduction

Need balancing between technical and economical

feasibility

Engineering economy should be used to attain

acceptable balance

Chapter # 2 integrates cost concepts, principles ofengineering economy and design consideration


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Cost Estimating

The process by which the present and future cost consequences of engineeringdesigns are forecast

Most prospective characteristics

Projectsrelatively unique

Based on past outcomes and adjust the data

Involve personnel from several sectors

Purposes

Provide information used in setting a selling price for quoting, bidding, orevaluating contracts

Determine whether a proposed product can be made and distributed at a profit (for

simplicity, price=cost + profit) Evaluate how much capital can be justified for process changes or other

improvements

Establish benchmarks for productivity improvement programs


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Cost EstimatingApproaches

Top-down Approach

Uses historical data for current projects - costs, revenues, andother parameters

Modifies original data for changes in inflation/deflation, activitylevel, weight, energy consumption, size, etc...

Works well at earlier stages of the estimation

Bottom-up Approach More detailed method of cost estimating

Break down a project into small, manageable units and estimate

costs and economic consequences Works best when details concerning desired output are

defined and clarified


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Origins of Engineering Economy


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Fixed, Variable & Incremental Costs

Fixed Cost

Those unaffected by changes in activity level over afeasible range of operations for the capacity or capabilityavailable

Variable Costs Those associated with an operation that vary in total with

the quantity of output or other measures of activity level

Incremental Costs or Incremental Revenue The additional cost or revenue that results from increasing

the output of a system by one (or more) units


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Example 2-1

In connection with surfacing a new highway, a contractor has a choice of two sites on whichto set up the asphalt-mixing plant equipment. The contractor estimates that it will cost $1.15

per cubic yard per mile (yd/mile) to haul the asphalt-paving material from the mixing plant tothe job location. Factors relating to the two mixing sites are as follows (production costs ateach site are the same):

The job requires 50,000 cubic yards of mixed-asphalt-paving material. It is estimated thatfour months (17 weeks of five working days per week) will be required for the job. Comparethe two sites in terms of their fixed, variable, and total costs. Assume that the cost of thereturn trip is negligible. Which is the better site? For the selected site, how many cubicyards of paving material does the contractor have to deliver before starting to make a profitif paid $8.05 per cubic yard delivered to the job location?

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Cost Factor Site A Site BAverage hauling distance 6 miles 4.3 milesMonthly rental of site $1,000 $5,000Cost to set up and remove equipment $15,000 $25,000Hauling expense $1.15/yd3-mile$1.15/yd3-mileFlag person Not required $96/day


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Example 2-1

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Cost Factor Site A Site B

Average hauling distance 6 miles 4.3 miles

Monthly rental of site $1,000 $5,000

Cost to set up and remove equipment $15,000 $25,000

Hauling expense $1.15/yd3- mile $1.15/yd3- mile

Flag person Not required $96/day

Select a site among A & B (tables) ?

Requires 50,000 yd3at job location

1.15/yd3-mile for asphalt mixing plant

production costs at each site are the same

4 month ( 17 weeks x 5 days)

Break even with paid $8.05 / yd3?


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Example 2-1

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Cost Fixed Variable Site A Site B

Rent X = $ 4,000 = $ 20,000

Setup/removal X = 15,000 = 25,000

Flag person X = 0 5(17)($96) = 8,160

Hauling X 6(50,000) ($1.15) = 45,000 4.3(50,000)($1.15) = 247,250

Total: $ 364,000 = $300,410

Select B : larger fixed cost + smaller variable cost

Profit (break even)

4.3 ($1.15) = $4.945/ yd3

Total Cost = Total Revenue

fixed + variable = Revenue

$53,160 + $4.945 X= $8.05 x $4.945

X= 17,121 yd3delivered


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Example 2-2

Problem : Cost for trips

4 students 400 miles driving x 2 ways

Cost list (table)

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Cost Element Cost per mile

Gasoline $0.120

Oil and lubrication 0.021

Tires 0.027

Depreciation 0.150

Insurance and taxes 0.024Repairs 0.030

Garage 0.012

Total $0.384

*

**

*


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Example 2-2

Solution 1 (Car owner)

Cost/mile = $ 0.384 (annual average 15,000 miles) 0.384 x 800 mile = $ 102.4 x 3

Solution 2 (Other students)

Cost/mile = $ 0.198 (Gasoline, Oil and lubrication, Tires, Repairs) 0.198 x 800 mile = $ 158.40 = $ 52.80 x 3

Solution 3 (considering additional miles)

15,000 x $0.384 = $5760 18,000 x $ ? = $6570 (given cost service)

$810 / 3,000 = $0.270

0.27 x 800 mile = $216.00 = $72.00 x 3

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Direct, Indirect and Standard Costs

Direct costs

reasonably measured and allocated to a specific output or work activity labor and material directly allocated with a product, service or construction

activity

ex: material cost for a pair of scissors

Indirect costs

difficult to allocate to a specific output or activity

costs allocated through a selected formula (such as, proportional to direct

labor hours, direct labor cost, direct material cost, or others)

ex: costs of common tools, general supplies, and equipment maintenance indirect costs = overhead = burden

ex: electricity, general repairs, property taxes, supervision

administrative selling expensesadded to direct cost

allocate overheads costs among product/services/activates


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Direct, Indirect and Standard Costs

Standard Costs

representative costs/unit established in advance

developed from anticipated direct labor hours, materials,overhead categories with their established costs per unit

Important role in cost control and other management

some typical uses are the following: estimating future manufacturing costs

measuring operating performance by comparing actual costper unit with the standard unit cost

preparing bids on products or services requested bycustomers

establishing the value of work in process and finishedinventories


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Standard Costs

Standard Cost Element Sources of Data for Standard Costs

Direct Labor

+

Direct Material

+

Factory Overheads

Process Routing sheets, standard times,standard labor rates

Material quantities per unit, standard unit

material costs

Total factory overhead costs allocatedbased on prime costs (direct labor plusdirect material costs)

= Standard cost (per unit)


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Cash Cost versus Book Cost

Cash cost

a cost that involves payment in cash and results in cash flow future transaction (potential) incurred for the alternatives

Book cost

costs that do not involve cash payment but rather represent therecovery of past expenditures over a fixed period of time such asdepreciation

depreciation

is not a cash flow

only affects income taxes, cash flow

EE needs to consider only cash flows or potential cash flows


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Sunk Cost

Sunk cost

one that has occurred in the past has no relevance to estimates of future costs and revenues related to an

alternative course of action

nonrefundable cash outlays

ex motorcycle 1 -$40 (down payment) + $1260 = $1300

motorcycle 2 - $40 (down payment) + $1230 = $1270 emotionally difficult to do

Example 2-3

Original Purchasing Price - $50,000

Current Book value - $ 20,000 Current Market price - $5,000

Sunk Cost

View 1 - $50,000 : sunk cost for replacement

View 2 - $15,000 : difference between real value and book value


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Opportunity Cost

Opportunity cost

the cost of the best rejected (i.e., foregone) opportunity

Incurred because of the limited resources

Ex: Student for working - $20,000

for going to school - $5,000 (expenses)

opportunity cost - $25,000 ($5,000 cash outlay and

$20,000 for income foregone)


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Example 2-4

Purchasing - $50,000

Book value - $ 20,000

Market price - $5,000

By keeping the equipment, the firm is giving up the

opportunity to obtain $5,000 from its disposal $5,000 immediate selling price is really the

investment cost of not replacing the equipment andis based on the opportunity cost concept

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LifeCycle Cost

Summation of all costs

both recurring and nonrecurring related to a product, structure, system, or service during its life

span

Life cycle begins with the identification of the economic need or want

ends with the retirement and disposal activities

functional or economic basis (shorter than functional)

ex: old boiler may be able to produce the steam required, but not

economically enough for the intended use

Fi 2 1 Ph f th Lif C l d Th i


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Figure 2-1 Phases of the Life Cycle and TheirRelative Cost

Fig re 2 2 Costs of Design Changes Are


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Figure 2-2 Costs of Design Changes AreSignificant


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LifeCycle Cost

Investment cost

capital required in acquisition phase

a single or a series of expenditure

capital investment

Working capital

funds required for current assets for start up & operational activities

materials in inventory for delivery spare parts, tools, personnel for maintenance

cash for employee salaries, other expenses

Operation & Maintenance cost

recurring annual expense items

people, machine, materials, energy & information

Disposal cost

nonrecurring cost

be offset by remaining market value


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Example 2-5

Consider the situation where equipment and related support for a newcomputer aided design / computer-aided manufacturing work station are beingacquired for the engineering department that you work in. The applicable costelements and estimated expenditures are as follows:

What is the investment of this CAD/CAM software?

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Cost Element Cost

Install a leased telephone line for communication $1,100/month

Lease CAD/CAM software (includes installation & debugging) 500/month

Purchase hardware (CAD/CAM workstation) 20,000

Purchase 9600-baud modem 2,500

Purchase a high-speed printer 1,500

Purchase four-color plotter 10,000Shipping costs 500

Initial training (in house) to gain proficiency with CAD/CAM software


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The General Economy

Environment


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Consumer / Producer Goods and Services

Consumer goods/services

products or services, directly used by people ex: food, clothing, homes, cars, TV sets, opera,

haircuts, and medical services etc

Producers must be aware of the changing wants of the

people

Producer goods/services

products or services to produce consumer goods andservices or other producer goods

ex: machine tools, factory buildings, buses, etc


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Measures of Economic Worth

Goods/services are produced and desired because

directly or indirectly they have UTILITY.

Utility

measure of the value which consumers of a product orservice place on that product or service

power to satisfy human wants and needs

commonly measured in terms of value, expressed in

some medium of exchange as the price


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Necessities, Luxuries, and Price Demand

Necessities and luxuriesTwo types of goods and services

These terms are relative one person considers Goods/Services a necessity, another

considers it a luxury

Price - equals some constant value minus some multiple ofthe quantity demanded

p = abD for 0 D a/b, and a>0, b>o (2-1)

D = (ap) / b (b0) (2-2) Lower price - Large demand

p= abD

Price

:p

Units of Demand : D

Price Demand Relationship for Luxuries &


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Price-Demand Relationship for Luxuries &Necessities

Extent to which price changesinfluence demand varies accordingto the elasticity of demand

Demand is elastic when a decreasein selling price results in

considerable increase in sales

If a change in selling price produceslittle or no effect on demand, thedemand is said to be inelastic

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Competition

Competition exists in general economic situations

Perfect competition product is supplied by a large number of vendors

no restriction on additional suppliers

complete freedom on the part of both buyer and seller

may never occur in actual practice.

Monopoly opposite from perfect competition

products/service is only available from a single supplier

prevent the entry of all others

perfect monopolies rarely occur in practice

Oligopoly when there are so few suppliers of a product or service that action by one

will almost inevitably result in similar action by the other


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Total Revenue Function

Total Revenue TR = price demand =p(D) (2-3) TR = (abD) D= aDbD2for 0 D a/b, and a>0, b>0 (2-4)

Maximum revenue For MR, dTR/dD = a2bD = 0 (2-5)

D = a / 2b (2-6)

MR = aDbD2

= a(a/2b)b(a/2b) 2

= a2

/2b - a2

/4b= a2/4b

Cost Volume and Breakeven Point


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Cost, Volume, and Breakeven PointRelationships

Scenario 1: p= a- bD, Larger Volumelower priceProfit is maximized where total revenue exceeds total cost bygreatest amount

CT

= CF

+ CV

CV= cv. D


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Max Profit

D* occurs where Profit (total revenue - total costs) ismaximized

PR = (aD-bD2) - (CF+CvD) = -bD2+(a-Cv)D - CF (2-9)

dPR/dD=0 D* = [ a - Cv]/2b (2-10)

Breakeven points (D1, D2) occur when

TR = CTor Profit = 0

-bD2+(a-Cv)D - CF= 0 D = [-(a - Cv) +/- {(a-Cv)

2- 4(-b)(-CF)}1/2]/2(-b)

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Example 26

A company producing electronic timing switch.

Per month: Cf= $73; 000 and Cv= $83

Moreover,p= $1800.02(D)

Determine:(a) Optimal volume and confirm that a profit occurs at

this demand

(b) Volume at which breakeven occurs


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Example 26

A company produces an electronic timing switch that is used in consumerand commercial products made by several other manufacturing firms. Thefixed cost (Cf) is $73,000 per month, and the variable cost (cv)is $83 perunit. The selling price per unit isp -$180 - 0.02(D), based on Equation (2-1). For this situation:

a) Determine the optimal volume for this product and confirm that

a profit occurs (instead of a loss) at this demand, and

b) Find the volumes at which breakeven occurs; that is, what isthe domain of profitable demand?

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Example 2-6

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Example 2-6

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Example 2-7

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E l 2 7


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Example 2-7

E l 2 7


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Example 2-7

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Thus, the breakevenpoint is more sensitiveto a reduction invariable cost per hourthan to the samepercentage reductionin the fixed cost

Furthermore, noticethat the breakevenpoint in this exampleis highly sensitive tothe selling price per

unit,p.

P t E St di


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Present Economy Studies

Present Economy Study

When the influence of time on money is not significant consideration, costanalysis

One year or less period

Rule 1 When revenues and other economic benefits are present and vary among

alternatives, choose the alternative that maximizes overall profitability

based on the number of defect-free units of a product or service produced

Rule 2

When revenues and other economic benefits are not present or are constant

among all alternatives, consider only the costs and select the alternative that

minimizes total costper defect-free unit of product or service output

P t E St di


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Total Cost in Material Selection

Material selection cannot be based solely on costs of materials. Change in materials frequently affect design, processing, and

shipping costs.

Alternative Machine Speeds Machine speeds result in different rates of product output and

frequencies of machine downtime.

Such situations lead to present economy studies

P t E St di


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Make vs. Purchase (Outsourcing) Studies

Short run production, one year or less Choose Make rather than Purchase at a price lower than

production costs if:

Costs (direct, indirect, overhead) are incurred regardless of whetherthe item is purchased

Incremental production cost is less than purchase price

Decision, based on

incremental costs

opportunity costs of resources

For long run, capital investments in additional manufacturing plantmay be feasible alternatives

E l T t l C t i M t i l S l ti


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Example : Total Cost in Material Selection

A good example of this situation is illustrated by a part for which annual

demand is 100,000 units. The part is produced on a high-speed turretlathe, using 1112 screw-machine steel costing $0.30 per pound. Astudy was conducted to determine whether it might be cheaper to usebrass screw stock, costing $1.40 per pound. Because the weight ofsteel required per piece was 0.0353 pounds and that of brass was

0.0384 pounds, the material cost per piece was $0.0106 for steel and$0.0538 for brass. However, when the manufacturing engineeringdepartment was consulted, it was found that, although 57.1 defect-freeparts per hour were being produced by using steel, the output wouldbe 102.9 defect- free parts per hour if brass were used. Which material

should be used for this part?

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E l S l ti


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Example : Solution

The machine attendant was paid $7.50 per hour, and the variable (i.e.,traceable) overhead costs for the turret lathe were estimated to be $10.00 perhour. Thus, the total-cost comparison for the two materials is as follows:

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1112 Steel BrassMaterial $0.30 x 0.0353 = $0.0106 $1.40 x 0.0384 = $0.0538Labor

$7.50/57.1

= 0.1313

$7.50/102.9

= 0.0729

Overhead $10.00/57.1 = 0.1751 $10.00/102.9 = 0.0972Total cost per piece $0.4484 $0.2968Saving per piece by use of brass = $0.3179 - $0.2239 = $0.0931

Because a large number of parts are made each year, the saving of $93.10per thousand was a substantial amount. It is also clear that costs other thanthe cost of material are of basic importance in the economy study

E l


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ExampleLater history of same product illustrates that shipping costs also must often beconsidered in selecting between materials. It was found desirable to supply domestic /foreign assembly plants of company by using air freight for shipping. This led to a

study of the possible use of a heat-treated Al alloy. This material cost $0.85/poundand the cost of a heat treating each part, at an outside plant, was $0.018. Productionstudies indicated that Al alloy could be machined at the same speeds as brass stock.Specific gravities of brass and Al alloy are 8.7 and 2.75 respectively.

Consequently, comparative costs, including shipping at $3.00/lb of finished part is:

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Brass (lb) Aluminum Alloy (lb)

Raw Material 0.0384 (0.0384)(2.75/8.8) = 0.01213Finished Part 0.0150 (0.0150)(2.75/8.8) = 0.00474

Brass (lb) Aluminum Alloy (lb)

Material $1.40 x 0.0384 = $0.0538 $0.85 x 0.01213 = $0.0103Labor $7.50 / 102.90 = $0.0729 $7.50 / 102.90 = $0.0729

Heat treatment - = $0.0180

Overhead $10 / 102.90 = $0.0972 $10 / 102.90 = $0.0972

Shipping $3.00 x 0.0150 = $0.0450 $3.00 x 0.00474 = $0.0142


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E ample Sol tion


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Example : Solution

Because the labor cost for the crew would be the same for either

speed of operation and because there was no discernibledifference in wear upon the planer, these factors did not have tobe included in the study.

In problems of this type, the operating time plus the delay timedue to the necessity for tool changes constitute a cycle time that

determines the output from the machine. The time required for acomplete cycle determines the number of cycles that can beaccomplished in a period of available time (e.g., one day), and a

certain portion of each complete cycle is productive. The actualproductive time will be the product of the productive time percycle and the number of cycles per day

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Example : Solution


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Example : Solution

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At 5,000 feet per minuteCycle time = 2 hours + 0.25 hour = 2.25 hoursCycles per day = 8 2.25 = 3.555

Value added by planing = 3.555 x 2 x 1,000 x $0.10 =Cost of resharpening blades = 3.555 x $10 = $35.55Cost of blades = 3.555 x $50/10 = 17.78

Total cost

Net increase in value (profit) per day

$711.00

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$657.67

At 6,000 feet per minuteCycle time = 1.5 hours + 0.25 hour = 1.75 hoursCycles per day = 8 1.75 = 4.57Value added by planing = 4.57 x 1.5 x 1,200 x $0.10 =Cost of resharpening blades = 4.57 x $10 = $45.70Cost of blades = 4.57 x $50/10 = 22.85

Total cost

Net increase in value (profit) per day

$822.00

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$754.05

(cycles/day)(hours/cycle)(board feet/hour)(dollar value/board-foot) = dollars/day


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Example 2 8


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Example 2-8

If the manufacture of Product X is discontinued, the firm will save at most$90.00 in direct labor, $86.40 in direct materials, and $3.00 in variable

overhead costs, which totals $179.40 per day. This estimate of actual costsavings per day is less than the potential savings indicated by the costaccounting records ($288.40 per day), and it would not exceed the S201.60 tobe paid to the outside company if Product X is purchased. For this reason, theplant manager used Rule 2 and rejected the proposal of the foreman and

continued the manufacture of Product X.

In conclusion, Example 2-8 shows how an erroneous decision might be madeby using the unit cost of Product X from the cost accounting records withoutdetailed analysis. The fixed cost portion of Product X's unit cost, which is

present even if the manufacture of Product X is discontinued, was not properlyaccounted for in the original analysis by the foreman

Documents

Engineering Economy Chapter # 02