CHAPTER 2

Fundamental Cost
Concepts
(Part 1)
The objective of Chapter 2 is to present
various of costs categories in an
engineering economy analysis.
 CONTENT
2.1 Introduction
2.2 Cost Terminology
2.3 Fixed Cost, Variable Costs and Total Costs
2.4 Recurring and Nonrecurring Cost
2.5 Direct, Indirect and Standard Costs
2.6 Cash Cost versus Book Cost
2.7 Sunk Cost
2.8 Opportunity Cost
2.9 Life-Cycle Cost
2.1 Introduction
The concept of cost is a key concept in Economics. It refers to the amount of
payment made to acquire any goods and services. In a simpler way, the
concept of cost is a financial valuation of resources, materials, undergone risks,
time and utilities consumed to purchase goods and services.
2.2 Cost Categorization / Terminology
The cost categorizes in varies classification according to
the frequency of occurrence, relative magnitude, and
degree of impact on the study.

Variable Incremental
Fixed costs Cash costs Book costs
costs costs

Indirect Standard Opportunity

Direct costs Sunk costs
costs costs costs

Lifecycle Investment Working Disposal

O & M Costs
costs costs capital Costs
 2.3 Fixed Cost, Variable Costs and
Total Costs
• Fixed cost: unaffected by changes in activity level over a
feasible range of operations for capacity or capability available.
Typical fixed costs include salaries, utilizes, insurance, taxes
and interest costs on borrowed capital.

• Variable cost: those associated with an operation that

varies in total with the quantity of output or other measure of
activity level. For example, the costs of service and
maintenance, material and labor used in a product or service
are variable costs, because they vary total with the number of
output units.
• Total cost : an incremental cost (or incremental revenue) is
the total of cost resulting from fixed cost & variable cost.

TC = VC + FC
= aQ + FC ,
where, Q= output , a variable number
Example 1 : Refer Sullivian’s book

• Fixed cost: unaffected by changes in activity level.

• Variable cost: vary in total with the quantity of output (or

similar measure of activity)

• Incremental cost: additional cost resulting from increasing

output of a system by one (or more) units
Example 2 : Refer Rosnah Mohamad Sirin’s book

For mixing 1m3 concrete require variable cost of RM5 and

a fixed cost per day is RM 100.

(a) Produce Linear equations concrete production costs.

(b) Estimated production costs for 1000 m3 of concrete

mixed in a day.
Solution

a)If FC=100 per day, VC= RM5 per day, if the output is Q m3 of
concrete per day, while the cost of change is 5Q
TC=FC+aQ
TC=100+5Q

b) Total production 1000 m3 of concrete per day

TC=100+5(1000)
TC=RM5100
Example 3: Refer Rosnah Mohamad Sirin’s book

The cost to produce 10 shirts is RM350, while RM600

are required to produce 20 shirts.

(a) Produce Linear equations shirts production costs.

(b) If production increased to 100 pieces shirt for the next

month, calculate the total production for the shirts.
Solution:

(a) TC1=350, Q1=10

TC2=600, Q2=20

TC1=FC+aQ1 TC2=FC+aQ2
350=FC+a(10)…..(1) 600=FC+a(20)……(2)

250=a(10)
a=25
Replace a into equations (1), 350=FC+25(10)
FC=100
Cost Equation, TC = 100+25Q
(b) TC = 100 + 25(100) = RM2600
2.4 Recurring and Non-recurring Cost
• Recurring - Annual expenses items for direct
& indirect cost associated with five primary
resouces
Ex. people, machines, materials, energy
& information - major part expenses
• Non-recurring – Cost Expenses for shutting
down operation & retirement & disposal of
assests
Ex. Personnal, materials, transportation
etc
2.5 Direct, Indirect & Standard Costs
Direct:
• can be measured and allocated to a specific work
activity
• Ex: Labour cost and material costs

Indirect
• difficult to attribute or allocate to a specific output or
work activity, usually involve overhead or burden
• Ex: Cost of equipment repair and maintenance.

Standard Cost
• are planned cost per unit of output, established in
advance of production or service delivery
• Ex: controlled and standardised price rate for a
particular job or activites .
2.5 Direct, Indirect & Standard Costs

Typical uses of STANDARD COSTS:

• Estimating future manufacturing

costs.

• Measuring operating performance

by comparing actual cost per unit
with the standard unit cost.
S-curve showed for site progress
• Preparing bids requested by (actual vs progress)

customers.
2.6 Cash Cost versus Book Cost
CASH COST BOOK COST

• a cost that involves a • a cost that does not involve

payment of cash a cash payment
• results in a cash flow • Represent some change in
value over a particular
period of time
(depreciation value).
2.7 Sunk cost
• A cost that has occurred in the past and has no
relevance to estimates of future costs and
revenues related to an alternative course of
action.
• Irretrievable consequences of past decision so
become irrelevant in the economy analysis.
• Sunk cost: a cost that has occurred in the past and has no
relevance to estimates of future costs and revenues
related to an alternative course of action.
kos rugi yang telah dikeluarkan sebelum ini dan hangus begitu
shj.

Example 1 pg 46:
Joe College finds a motorcycle he likes and pays $40 as a down
payment, which will be applied to the $1,300 purchase price, but
which must be forfeited if he decides not to take the cycle. Over
the weekend, Joe finds another motorcycle he considers equally
desirable for a purchase price of $1,230. for the purpose of
deciding which cycle to purchase, the $40 is a sunk cost and
thus would not enter into the decision, except that it lowers the
remaining cost of the first cycle. The decision then is between
paying an additional $1,260 ($1,300 - $40) for the first
motorcycle versus $1,230 for the second motorcycle.
Example 2 :
Tender of project by government..RM200/per document ?
2.8 Opportunity cost
• The cost associated with an opportunity that is declined.
It represents the benefit that would have been received if
the opportunity were accepted.
• The monetary advantage foregone due to limited
resources.
• Eg: Consider a student who could earn $20,000 for
working during a year, but choose instead to go to
school for a year and spend $5,000 to do so. In this
case, the student giving up the opportunity costs to earn
$20,000
• Opportunity cost: the monetary advantage foregone due
to limited resources. The cost of the best rejected
opportunity.
kos peluang yang dapat ditepikan / ditolak secara
tersirat

Example 1 pg 47:
Consider a student who could earn $ 20,000 for working
during a year, but choose instead to go to school for a year
and spend $ 5,000 to do so. The opportunity cost of going to
school for that year is $ 25,000 ($ 5,000 cash outlay and $
20,000 for income foregone .This figure neglects the influence
of income taxes and assumes that the student has no earning
capability while in school.
Example 2:
Company must pay for income tax for every year. Cost for
reduce tax ex: entertains client, bonus for staff etc.
 What have you learn today?

Exercise Q1 :

Classify each of the following cost items as mostly fixed

or variable.

Raw materials Administrative salaries

Direct labor Insurance
Depreciation Office rent
Supplies Utilities
Services & Maintenances Property taxes
Exercise Q2
A manufacturer purchased and installed a production machine

6 years ago at a cost of $40,000. Since then, the machine has

been depreciated for tax purposes to a value of $7,000 and it

now requires replacement. A new machine will be purchased

for $60,000 and the old machine sold to a used equipment

dealer for $10,000.

Which of the four dollar values above is a book cost?

A. $7,000 B. $10,000

C. $40,000 D. $60,000
Exercise Q3 :

The total cost of repairing the two stores is RM1160. While

the 10 stores, costs improved to RM1800.
(a) Produce linear equations of the store.
(b) Calculate the fixed cost, variable costs and total
cost of repairing 5 stores.
Exercise Q4 :

A company charged RM70 to move a machine at a distance

of 15km. While RM100 is imposed if the distance increased to
25km.
(a) Produce linear cost equation for moving the machine.
(b) Calculate the fixed cost, variable costs and total cost
for 50km distance.
Lets recap!
Are you ready to test
your
understanding?
Scenario A
Three years ago, an engineering student purchased a notebook PC
for $2,800. The student now wishes to sell the computer. The
$2,800 initial cost is an irrelevant, ____________ that should play no
part in how the student establishes the minimum selling price for
the PC.

SUNK COSTS OPPORTUNITY COSTS

Scenario B
Suppose a product distributor decides to construct a new distribution
center instead of leasing a building. Leasing a building immediately would
have resulted in a $12,000 product distribution cost savings during the
next 6 months while the new warehouse is being constructed. By forgoing
the warehouse leasing alternative, the distributor experiences an
_________________of $12,000.