1

Understanding Project Cost Elements

Lecture No. 22Chapter 9Fundamentals of Engineering EconomicsCopyright © 2008

2

Evaluation of a Fixed Asset– Equipment– Buildings

Valuation of Fixed Assets– Based on usable after-tax cash flows the asset

produces

Engineering Economic Decisions

3

Classifying Costs for Manufacturing Environment

Manufacturing Costs

Direct Materials

Direct Labor

Mfg. Overhead Non-manufacturing Costs

Overhead

Marketing

Administrative Functions

4

Cost Flows and Classifications for Financial Statements Matching Concept: The costs

incurred to generate particular revenue should be recognized as expenses in the same period that the revenue is recognized.

Period costs: Those costs that are matched against revenues on a time period basis

Product costs: Those costs that are matched against revenues on a product basis.

5

Classifying Costs for Predicting Cost Behavior

Volume index Cost Behaviors

Fixed costs Variable costs Mixed costs

Break-Even Sales Volume

6

Volume Index

Def: The unit measure used to define “volume”

Examples: Automobile – “miles”

driven Generating plant – “kWh”

produced Stamping machine –

“parts” stamped Assembly plant – “units”

assembled

7

Fixed Costs Def: The costs of providing

a company’s basic operating capacity

Cost behavior: Remain constant over the relevant range

Typical examples: building rents, depreciation of buildings, machinery and equipment

8

Variable Costs

Def: Costs that vary depending on the level of production or sales

Cost behavior: Increase or decrease proportionally according to the level of volume

Typical examples: direct labor cost, material cost, and fuel consumption

9

Mixed Costs

Def: a cost with both fixed and variable elements

Cost Behavior: y = a + bx, where “a” is a fixed cost

Typical examples: cost of electric power (lighting/heating/ac – fixed; power consumption by operating equipment – variable)

Tot

al c

ost

Operating Volume, X

a

0

10

Average Unit Cost

Def: activity cost per unit basis

Cost Behaviors: Fixed cost per unit varies

with changes in volume. Variable cost per unit of

volume is a constant.

11

Contribution Margin/Break-Even Sales Volume Unit contribution margin

Unit contribution margin = unit sales price – unit variable cost

Contribution margin Contribution margin = total sales revenue – total

variable costs Break-even sales volume

Fixed expensesBreak-Even Point =

Unit contribution margin

12

Example 9.1 Break-Even Sales Volume Monthly break-even

point:

Number of units to be sold to make $50,000 profit before tax:

13

Cost-Volume-Profit Graph

14

Why Do We Use Cash Flow in Project Evaluation?

Company A Company B

Year 1 Net income

Cash flow

$1,000,000

1,000,000

$1,000,000

0

Year 2 Net income

Cash flow

1,000,000

1,000,000

1,000,000

2,000,000

Example: Both companies (A & B) have the same amount ofnet income and cash sum over 2 years, but Company A returns $1 million cash yearly, while Company B returns $2 millionat the end of 2nd year. Company A can invest $1 million in year1, while Company B has nothing to invest during the same period.

15

What Income Tax Rate Should be Used in Project Analysis?

Regular Business

Project

Revenues

Expenses

$200,000

$130,000

$40,000

$20,000

Taxable Income

Income Taxes

$70,000

$12,500

$20,000

?

16

Before Undertaking

Project

After Undertaking

Project

The Effect

of Project

Gross revenue $200,000 $240,000 $40,000

Expenses 130,000 150,000 20,000

Taxable income $70,000 $90,000 $20,000

Income taxes $12,500 $18,850 $6,350

Average tax rate 17.86% 20.94% 31.75%

This is the tax rate that should be used in project evaluation.

Incremental Income Tax Rate

17

Before After Incremental

Taxable income $70,000 $90,000 $20,000

Income taxes 12,500 18,850 6,350

Average tax rate 17.86% 20.94%

Incremental tax rate 31.75%

$0 $20,000 $40,000 $60,000 $80,000 $100,000

Regular income from operation

$20,000 incrementaltaxable income due toundertaking the project

Marginal tax rate15% 25% 34%

$5,000at 25%

$15,000at 34%

0.25($5,000/$20,000) + 0.34($15,000/$20,000) = 31.75%

Graphical Illustration of Incremental Tax Rate