Section1 Cost

8/3/2019 Section1 Cost

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C O S T


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Cost Element

Chapter 1


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What is COST?

Cost The price paid to acquire, produce,accomplish, or maintain anything.

Cost The total spent for goods or services including

money, time and labor. Cost is the value of money that has been used up to

produce something, and hence is not available foruse anymore.

Cost is the key element of triple constraint (Time,Cost, & Scope) by which project performance will beassessed.

Creating Evaluating Analysis Applying Understanding Remembering


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Learning Objectives

At the end of this session, you should able to:

Understand what cost constitutes;

Understand Direct Cost, Indirect Cost, Fixed Cost & VariableCost

Understand the application of life cycle costing

Use the cost element to measure, apply, and record togenerate total activity and/or asset cost



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Concepts

Cost is the total value of an assets or activity.

To arrive to this value, the cost of the resources

utilized to perform activity or to create assets iscalculated.

Resources are categorized in to: Material

Labor

Other



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Cost Categories

Material

Material are not only the physical part of an asset, but also

includes failure cost like scraps, construction form works, safetyitems, and logistics cost to transport the material to the work

place.

Labor

The cost incurred for the entire project team from laborer to

foreman to project engineer to project manager.

Other

These cost categories are required to support the work. Cost

expended for Equipments, Water, Electricity, Maintenance etc.,



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Cost Structuring

Cost structuring will help to get clear picture ofhow the cost is expended on the project like

whether it is a direct cost or indirect cost. If it is direct or indirect cost, is it fixed or variable

cost ?

By classifying the cost in to direct, indirect, fixed, &

variable, the management can understand the costexpended for your project precisely which helps todo effective Estimating, Budgeting & Cost Control.



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Cost Structuring: Direct Costs

The cost which is expended solely for the purposecompleting activities or assets for any given

project. These costs cannot be shared among otherprojects.

Direct cost are costs that can be associated with aparticular cost object.



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Cost Structuring: Indirect Costs

Indirect costs are costs that are not directlyaccountable to a particular activity or asset.

Indirect costs include taxes, administration,personnel and security costs.

Indirect Costs are also known as OverheadCostsor BurdenCosts.


Direct Cost + Overhead Cost = Total Object Cost


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Cost Structuring: Fixed Costs

Fixed costs are expenses whose total does notchange in proportion to the activity of a business /

project, within the relevant time period or scale ofproduction.

Fixed salary, Office Rent, Rented Crane for a fixedperiod of time, etc., are all examples of fixed cost.

Fixed cost can be direct cost or indirect cost.



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Cost Structuring: Variable Costs

Variable costs are expenses that change inproportion to the activity of a business / project.

Variable Costs can be direct cost or indirect cost.



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Cost Accounting

Cost accounting is the process of tracking,recording and analyzing costs associated with the

products or activities of an organization.



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Code of Accounts / Chart of Accounts

Based on the business practices, organization usesCode of Accounts / Chart of Accounts to categoriescost into groups to enter in to company accountsledger.

Code of Accounts will be presented in numericcodes. For Example

2200 Accounts Receivable

2400 Inventory Materials and Supplies

7100 Site Preparation

7700 Electrical Systems



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Code of Accounts / WBS

Code of Accounts for projects will be generallybased on Work Breakdown Structure numbering

system.



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Cost Management

Cost element and Cost structuring will be useful forCost Management.

The information gathering by Cost Element andCost Structuring will be useful for: Cost Estimating

Cost Trending

Cost Forecasting Life-Cycle Costing


Discussed in detail in later session


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Cost Estimating

Cost Estimating predicts the resource requirementfor an activity or to create an asset and the cost

associate with it. For an accurate cost estimating, it is important to

have:

A clear scope

Cost element structure Historical information / Expert judgment



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Cost Trending

Cost trending uses historical information as a basisto estimate resource cost to complete an activity or

an asset. It refers to historical information to find

information's like:

How much did we spend for fixing tiles for the past 6 month

and how much square meter tiles has been fixed? What is our monthly cost for electricity usage for the past

one year?



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Cost Forecasting

Estimating focuses on estimating future activitiesand assets but in forecasting, the future cost

expenditure will be predicted based on the pastcost performance.

Estimate to Complete, Estimate at Completion,Variance at Completion are all examples of Cost

Forecasting.



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Life-Cycle Costing

Life-Cycle costing concerns with the costassociated in completing an activity or an assets

and more importantly the cost of maintaining theassets through-out its life time.

It includes service cost, maintenance cost, break-down cost etc.,

It calculates the cost associated with an asset fromits creation to disposal. Its an analysis of costassociated with product life cycle rather thanfocusing on project life cycle.



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Pricing

Chapter 2


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Cost vs. Pricing

Pricing is a cost we fix to buy or sell something.

Pricing uses a set of tools and techniques to fix a

price for project/business. To fix a price for a product, services, or anything,

we need key inputs like historical information,competitors information, WBS, Cost Estimation

etc.,



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Tools & Techniques of Pricing

Pricing Strategies

Sales and Revenues

Business and Economic Ratios Return on Investment

Return on Sales

Break-even analysis



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Pricing Strategies

Pricing strategies should be based on the givensituation.

When one is bidding for a project, there can be twosituations: Type I

Type II

Type I acquisition is to win the project and performit successfully and profitably.

Type II acquisition aims to win the project to get afoot hold in the industry.



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Return on Investment

Rate of Return (ROR) or Return on Investment(ROI), is the ratio of money gained or lost on an

investment relative to the amount of moneyinvested.

ROI is usually given as a percent rather thandecimal value.

SIMPLE ROI

(Gains Investment Cost) / Investment Cost



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Complex ROI

ROI, also called as DUPONT or Engineers methodin complex calculations.

It is the percentage relationship of the averageprofit to the original investment.

ROI=(average yearly profit during earninglife)/(original fixed investment + working capital)



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Other ROI Metrics

Return on Sales

Net Profit / Sales

Return on Assets Earnings before interest and taxes (EBIT) / Net Operating

Assets

Gross Profit Margin Ratio Gross Profit / Total Sales



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Break Even Analysis

The break even point for a product is the point

where total revenue received equals total costs

associated with the sale of the product. Terms in use:

Selling Price Each unit price which it is sold for

Variable Costs Varies in proportionate with volume

Contribution Margin Sales revenue Variable cost

Fixed Costs Remains constant irrespective of Sales

Units The number of items sold or produced



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Formula

Break Even Unit

X = FC / (SP-VC) or X = FC / CM

Break Even Revenue Break-even revenue = Break-even units X SP

Desirable Profit X = (FC + DP)/ CM



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Materials

Chapter 3


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Introduction

Materials are key substances used as inputs forprojects and production or manufacturing.

Materials must be procured in right quantity atright time, failure in doing so, results in costincrease.

There are other reasons also to have good

materials management system in place like: For material traceability purpose

For effective control of damages to the material

To reduce warehouse cost by following JIT system



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Learning Objectives

At the end of this session, you should able to:

Identify type of project materials;

Understand the issues involved in selecting and handlingmaterials;

Understand the principles of material purchasing andmanagement, including maintaining proper amount of stockto save money and avoid waste and production delays;

Understand possible safety hazards associated withmaterials and be aware of the regulations governing workerand material safety.



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Materials Competition

Materials to be used in the project ormanufacturing / production often have alternatives

or choices. Floor tiles is a good example. We can fix granite,

marble, Mosaic, etc., for the same functional use.

In the above case the materials compete with each

other in cost, constructability, customerpreference, maintenance, life time, quality, etc.,



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Materials Handling


Materials Handling Eq


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Materials Handling Principles

Unit load

Space utilization

Material traceability Mechanization

Shortest distance material movement

Maintenance of Materials Handling Equipments



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Materials Handling Decision Factors

While we take decisions on materials handling,the following are the four factors to be considered:

1. The type of materials to be handled2. Production flow type (job shop/batch process &

Continuous flow)

3. Type of facility

4. Cost of Materials Handling System



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Material Types

1. Raw Materials (minimum processing e.g..Gravel for road)

2. Bulk Materials (readily available with minimumlead time)

3. Fabricated Materials (bulk materials transformedinto custom-fit items piping system w/fittings)

4. Engineered/Designed Materials (substantialworking required to reach the final form pumps,motors, chillers, etc.)



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Raw Materials

It requires minimum amount of processing.



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Bulk Materials

Bulk materials are ready available

Bulk materials are transformed in to fabricated

material or Engineered/Designed Materials



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Fabricated Materials

Custom-fit item for project or production.Creating Evaluating Analysis Applying Understanding Remembering


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Engineering/Designed Materials

It requires substantial work in order to achieve itsfinal form.



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Production materials purchase and management

To complete an activity or to build an asset, weneed resources. These resources include materials.

Materials need to be procured for project oroperation, which becomes an important businessfunction.

Effectively materials procurement and handlingwill results in selling the products at competitiveprice.

The ideal materials quality, quantity, safety stockwill leads to cost optimization.



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Production materials purchase and management

Materials quality management is handled throughproper vendor surveillance and materials

traceability. Quality control plays a vital role in materials

purchase.

Should avoid gold-platting while purchasing

materials for the project/production.



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Materials Quantity

It is very important to consider the various factorslike material cost, storage cost, demand, etc., while

purchasing materials to make sure we dont overstock the materials and under stock the materials.

Economic Order Quantity comes for rescue. Itgives a precise amount of quantity to buy

considering all the factors.



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Economic Order Quantity - EOQ

EOQ Formula EOQ = [ (2 x D x P) / S]

D = Annual Demand

P = Purchase Order Cost S = Storage / Carrying Cost

Re-order Point RP = (O x R) + I

RP = Re-order point

O = Order Time R = Production Rate

I = Minimum Inventory level or safety stock



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EOQ - Example

A garden tractor manufacturer has a requirement for 15,000 enginesper year. The engines each cost $75. The order cost for a purchaseorder is $250. The storage Cost for the engines are $12 per year

which includes space costs and financing costs. EOQ = [ (2 x D x P) / S]

D = 15000

P= 250

S = 12

EOQ = 790



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Re-order Point

Assume that the production processes uses 60engines per day for the 60 garden tractors

produced per day. If the lead time for an order is 5days, and the safety stock level is 180 engines, whatis the reorder point?

RP = (O x R) + I

O = Order time = 5 R = Production Rate = 60 units per day

I = Minimum Inventory = 180 Engines

RP = (5 x 60) + 180 = 480 Units



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Just-In-Time Inventory Technique

Also known as KANBAN or 0% inventory.

JIT system follows the principles of 0% inventory,

it maintains its system in such a way that exactamount of required material will be delivered atthe required time and hence no need for

warehouse and safety stock.

System should be maintained proactively andcarefully as poor JIT system results in productionstoppage and loss of business due to unavailabilityof materials when it is required.



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Individual purchase orders and systems contract

Customized and costly materials purchase needs to gothrough the organization procurement process ofrequest seller response, rate the vendor, select the

vendor etc., For standard and routine purchases, the company may

receive bid from prospective vendor and signs contractwith them to received require materials quantity at

frequent interval and on demand with economicalprice adjustment.

The merits of this system is reduced procurement costand economies of scale



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Expediting

The purpose of expediting is to ensure that thematerials are delivered on-time as promised.

Expediting is a key aspects in Critical pathnetwork. All the activities in critical path shouldreceived its associated materials on time asplanned to ensure successful project completion.



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Plant Materials Management

There are not part of final product objective butrather supporting material for machines and

equipment which is a part of production operation. Examples are oils, solvents, grease, etc.,

Specialized Plant Materials Production equipment replacement parts

Unique machinery needs to purchase spare parts from OEMwith might require lead time



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Plant Materials Benchmarking

Plant materials usage and life cycle should beanalyzed through benchmarking.

Benchmarking is a practice of identify the bestorganization and follow their practices.

While selecting plant materials an organization canidentify the best performing organization and

follow their procedures and practices in plantmaterials procurement and maintenance.



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Materials waste product and Hazard issues

Users of hazardous materials should abide by the governmentalregulations.

These regulations will ensure that hazardous material information is

communicated to the employers and employees by labeling in workplace like warning signs, material safety data sheet etc.,

For e.g., OHSA requires material safety data sheets should be readilyavailable for all how may in need for it.

There are also local governmental rules on waste materials disposal

and allocation of a particular area for waste material disposal and itmight requires treatment of waste materials before disposal.



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Labor

Chapter 4


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Labor Classifications

Direct Labor

Personnel assigned to the work activities, who directlyproduce the product.

Indirect Labor Personnel assigned to tasks other than producing products

but they are required to complete the project.

Overhead Labor Personnel assigned to task, which cannot be identified with

a part of the work. Its a business expense independent ofthe volume of work. ( Refer Chapter 4, Page 4.1, Table 4.1 forexamples)



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Developing Labor Rates

Base wages

Fringe Benefits [Paid Time Off]

Medical & Life Insurance benefits Government Mandated benefits

Engineer/Contractor overhead and profit

Fully-Loaded or Billing Rate Overtime wages



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Weighted Average Rates / Crew Composition Rates

In a craft area, group of workers perform the taskwith different background, expertise etc., and their

salary ranges from low to high. Since we dont know who will be part of the team

while estimation, we can make some assumption inorder to develop a comparable base wage rate to

use. Weighted Average Rates method will be highly

useful in this scenario.



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Weighted Average Example

No Classification Hourly Base Wage Extension

2 Laborers $ 14 $ 28

1 Foreman $ 25 $ 25

4 Carpenters $ 18 $ 72


Average cost for the group = $ 125/7 = $ 17.85/hour with benefit adder of 30% = $ 23.1 / hour


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Indirect and Overhead Labor

Indirect and Overhead Labor were previouslydiscussed.

The cost incurred for Indirect and Overhead Laborwill be estimated by several methods. For e.g., Actual estimate of indirect and overhead labor

A percentage of Direct Cost (as directed by historical

information)



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Estimating Work Hours

Work hours estimation can be done only whenClass 3 estimation detail are available.

Class 3 estimate can be performed when therequirements of major equipments, layoutdrawings, rough quantity of materials, etc., aredetermined.



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Work Sampling

Work sampling is a technique to determine theproduction or unit rates for a specific activity.

Organization will use work sampling to developstrong estimation database by recording theduration of the sample work.



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Engineering

Chapter 5


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Introduction

Engineering is the basic foundation where productprevail.

With the advent of CAD/CAM, engineering is beingrevolutionized.

Development of project, product and processranges from simple to very complex and dynamic.

There were different development in engineeringfield to cater this need.



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Pure and Applied Research

New product development is based on research.There are broadly two categories:

Pure Research

This involves work without a product in mind. E.g., A Chemistresearching how two chemical compounds if mixed reacts.

Applied Research

This involves developing usable products or add new features to

existing products and it is typically carried out by organizations.



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Product, project, and process life cycle

The life cycle of product as well as project willinfluence design decision, including plant andequipment.



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CAD / CAE / CAM

CAD / CAE software involves the utilization ofcomputerized work stations and software,including database and computer graphics, toquickly develop a product, project, or processdesign.

CAM provides the counterpart advantage of

CAD/CAE software to the factory floor.



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Prototypes

Before large scale production it is wise to developprototypes to check the feasibility in terms ofdesign, performance, customer satisfaction etc.,

Advanced software's are available to createsimulations of actual physical products.

Computer simulations and prototypes will

consume time but it gives a guarantee of finalproduct performance.



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Patents and Trade Secrets

New product development and research are veryexpensive and company who spend enough moneyon R&D should reap the benefits.

Patents and Trade Secrets protect them fromothers copies their hard worked design secrets.

In united states, a patents duration is 17 years.

Until this competitors should be copy the originalproducer model otherwise they will face severe lawsuits.



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Product Liability

Product liability is a mean where those who getinjured or got damaged by the product theypurchased can get compensated.

Gone those old saying Buyer Beware now itsSeller Beware

While engineering team designs a product this

should be considered to avoid product recalls,warranty claims etc.,



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Product, Project, and Process Design

Standardization

Process Selection

Continuous production, and

Discrete production

Manufacturability

Constructability

CII defined constructability as the optimum use of construction knowledgeand experience in planning, design, procurement, and field operation to

achieve overall project objectives.

Make or Buy Decisions



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Engineering Production/Construction

Production Health and Safety

Facility Layout

Assembly and Flow Process Charts Quantitative Analysis in Facility Layout

Reengineering



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Equipment, Parts, and Tools

Chapter 6


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Introduction

Managing Equipment, Parts, and Tools includes:

Selecting

Purchasing

Tracking

Storing

Maintaining

Selling Equipment



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Equipment Valuation

Establishing an equipment valuation database is akey factor in project. It helps to base the estimate for new equipment requirement

for the project It helps to calculate the residual value for make or buy

decision

It helps project team to decide on trade-offs between menvs. machine

As equipment valuation database helps in keydecisive factor, emphasis should be given onquality of trade data.



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Equipment Value Categories

Equipment values are in two major categories:

1. Replacement Cost New (new equipment cost), and

2. Market Value (used equipment, secondary market value)



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Replacement Cost New

Reproduction Cost

Cost of a new identical equipment

Replacement Cost

Current cost of replacing a equipment with a new one of equal effectiveness. Furthermore,

replacement cost analysis takes into consideration the transportation and installation costs

required to facilitate normal operation.

Fair Value

Unbiased estimate of potential price considering

relative scarcity

perceived utility (economist's term for subjective value based on personal needs) potential risk/return characteristics (i.e., for a tradable asset)

production/distribution costs, including a cost of capital



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Market Value

Fair Market Value-in-Place Market value in place is the price at which equipment would

change hands between a willing and able buyer and seller, with

neither under compulsion to buy or sell, with both having fullknowledge of the relevant facts. Including delivery, installationand put in to operation.

Fair Market Value-in-Exchange or Retail Value The fair market value is the price at which the equipment would

change hands between a willing buyer and a willing seller throughthird party transaction, neither being under any compulsion tobuy or to sell and both having reasonable knowledge of relevantfacts.


k l


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Market Value

Orderly Liquidation Value

Orderly liquidation is the value realized when assets are soldpiecemeal, through negotiation, over a predetermined

period of time (often three to six months).

Orderly liquidation value assumes that the buyer isresponsible for all removal costs and is purchasing the assets"as is, where is'" with no warrantees or representations as to

the condition of the assets being made by the seller.


k l


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Market Value

Forced Liquidation Value / Under the hammer /Blow-out Value

Forced liquidation value is the value realized when assets aresold piecemeal, under duress at public auction.

Forced liquidation value assumes that the buyer is responsiblefor all costs of removal and is purchasing the assets "as is,where is" with no warrantees or representations as to the

condition of the assets being made by the seller. It is further assumed that the assets are properly advertised in

a manner considered to be commercially reasonable.


M k V l


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Market Value

Salvage Value / Part-One Value

The estimated value of an asset at the end of its useful life.

Scrap Value Scrap value is the value of equipment relates to basic

commodity value. (For example, Dollars per ton of steel)



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Valuation Example/Sub-Categories of Value

Type of Value Sales Price % of Highest Price

Fair Market Value-in-Place $300,000 100%

Fair Market Value-in-Exchange $225,000 75%

Orderly Liquidation Value $195,000 65%

Forced Liquidation Value $150,000 50%

Salvage/Part-One Value $24,000 8%

Scrap Value $6,000 2%


D S f R l C N


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Data Source for Replacement Cost New

Price list of manufacturers

Information provided by Sales Representative

Technical and trade journal publications Invoices, Purchase Orders from past purchases

Quotation received from vendors


D t S f M k t V l


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Data Source for Market Value

Advertisement for used equipments

Retail price received from used equipment dealer

Used Equipment price quotation received earlier Market Data Publication

Auction Sales Catalogs available from auctioncompanies

Past remarketing and sales return



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Market Value Example / Generator

Event Cost/Value

a. Purchase price as-is at auction $7,000 (Orderly Liquidation Sale)

b. Sales tax Exempt (Equipment Dealer)

c. De-installation $ 500

d. Cost of Money (estimated) time to sell 90 Days, 10% annual rate x 3 months x $7500 purchase

and install

$ 175

e. Overhead (20% of purchase price, includes some preparation and advertisement) $ 1400

f. Profit (15%-20%: use 20% of purchase price plus de-installation) $ 1500

g. Sub total (a+c+d+e+f) $ 10575 (min. desired selling price)

h. Ask (advertise for sale) $ 13000

i. Take (sale to end user) $ 10700 (fair market value-in-exchange)

j. Buyer (end user) pays sales tax (6%) $ 642

k. Delivery $ 750

I. Installation and debugging $ 2000

Total installed cost to end user (i+j+k+l) $ 14092 (fair market value in place)



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General Example Summary

Type of Market Value % of Value

Fair Market Value-in-Place

($ 14092)

100%

Fair Market Value-in-Exchange

($ 10700)

76%

Orderly Liquidated Value

($ 7000)

50%


T d D t /C t Adj t t


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Trade Data/Cost Adjustments

If similar equipments sales data are inconsistent, thefollowing adjustment should be considered beforenormalizing the data:

The newer equipment manufacturing date attracts more value

Different ancillary will add more value

Sales locale

Utilization

Condition of the equipment


Eq ipment Condition Terms and Definition


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Equipment Condition Terms and Definition

Very Good equipment in excellent appearance andbeing used to its full design specification

Good equipment that was modified or repaired andbeing used to its full or near full design specification

Fair equipment used at some point below fullyspecified utilization

Poor it requires extensive repair and replacement ofparts

Scrap no longer serviceable and cannot be utilized.


Data Filling Systems


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Data Filling Systems

Obtained data can be recorded on several ways:

Standard Industrial Classifications - #33 Machine Tools, #44Marine, etc

Equipment Class and Type tools-lathes, aircraft-commuter,construction-crawler crane

Industry Category Machine shop equipment, Construction,Mining, etc

Equipment Manufacturer name Caterpillar, Dewalt, etc., Data Storage

Collected information can be stored electronically or throughmanual filing system


Equipment Valuation


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Equipment Valuation

One of the most propelling question for estimatorsand appraisers is What is the residual value for theequipment?

There is no short cuts to arrive to an residual value todecide on leases or life cycle costing, it should becalculate based on hard work and years of experience.

The estimator or appraiser should understand theequipment and industry in which it operates. Heshould have access to trade data even though itdoesnt guarantee the correctness.


Residual Value Curves


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Residual Value Curves


Residual Value Curves Shapes


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Residual Value Curves Shapes

L Shaped Normal curve for long-lived equipments

U Shaped for Disrupted market or equipment

shortage Regulatory change curve which shows sudden impact

of the equipment

Truncated shape for high obsolescence equipment

New Tax Law or High Inflation shift in L Shape


Variables that affect residual value


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Variables that affect residual value

1. Initial cost

2. Maintenance

3. Use/Wear and tear

4. Population

5. Age6. Economy

7. Changes in Technology

8. Foreign Exchange

9. Tax Laws

10. Legislations/regulations

11. Location of equipment12. Method of Sales


Calculating Residual Values


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Calculating Residual Values

Calculating residual values considering all the factorsis very difficult.

Estimator / Appraisal can use all the available dataand predict residual value to its closest accuracy ispossible.

Calculating residual value for long term equipments

are quite challenging.


Residual Value Formats


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Residual Value Formats

Marketplace

Manufacturer

Model Run

Installation

Software

Versatility Life Expectancy

Residual Value

Manufacturing Market Place

Future Improvements

Price Increases

De-Installation

Conclusion


Residual Curves


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Residual Curves

Methodology1. A Complete market analysis and technical review of the equipment.

2. Current fair value after considering discounts and other generaloffers.

3. With fair value and all other trade data, valuation history iscompleted

4. After analyzing trade data, an average is determined and enteredonto the residual analysis line.

5. The residual value in percentage is calculated based on the givendata.

6. It has to be streamlined with other adjustment factors (Tax,Regulation)

7. Final Review and cross-checked with other curves.


Inflation Factors


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Inflation Factors

Residual value analysis does not consider inflationfactors. However, if one likes, he can apply inflationfactor in to the residual curve.

The correct Inflation index should be selected.



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Economic Costs

Chapter 7

Introduction


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Introduction

Economic cost is a wide-ranging area of importance for cost engineersand cost managers.

The project or a product, must be economically feasible to construct orproduce.

The price of the product is must be in a range that is affordable for itstarget market.

Globalization currency issues, inflation rates, taxation rates, etc.

Economic analysis techniques, properly applied, can pinpoint the

alternative with the most favorable cost aspects.


Introduction


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Introduction

Economic cost analysis will be performed to study

The feasibility of the project.

The feasibility of producing a product with in the acceptable

price range affordable by the buyer.


Concepts


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Concepts

Cost engineering professionals must make sensible decisions in thearena of economic costs. Often this task is complicated by the fact thatcertain elements of these decisions, such as costs, revenues and benefits,occur at different times in the life cycle of a project. For example,

manufacturing processes that proved economical over a lengthy periodof time may end up at a net negative cost when the downstream costs ofhazardous waste clean up are factored into the equation.

While no one can peer unerringly into the future, the more effective theanalysis of the totality of economic costs is, the better the resulting

decisions will be.

Taxation Policies, Depreciation rules, Currency Variations, etc.


Types of Costs


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Types of Costs

Opportunity Cost

Sunk Cost

Book Cost Incremental Cost


Opportunity Cost


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Opportunity Cost

In economics, opportunity cost, or economic cost, is the cost of

something in terms of an opportunity forgone (and the benefits which

could be received from that opportunity), or the most valuable forgone

alternative (or highest-valued option forgone), i.e. the second bestalternative.

For e.g., In building a hospital in a vacant land, the city has forgone the

opportunity to build a sporting center on that land, or a parking lot, or

the ability to sell the land to reduce the city's debt.

Note that opportunity cost is not the sum of the available alternatives,but rather of benefit of the best alternative of them. The land cannot be

used for more than one of purposes.


Sunk Costs


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Sunk Costs

In economics and in business decision-making, sunkcosts are costs that have already been incurred and

which cannot be recovered to any significant degree.Sunk costs represent funds already spent by virtue ofpast decisions.

Since these expenditures are in the past, by definition,

they should not influence current decisions. For E.g., if the owner can derive more value from

selling the car than not selling it, it should be sold,regardless of the price paid (sunkcost)


Book Costs


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Book Costs

Assets are carried on the firms books at original cost lessany depreciation.

Book costs represent the value of an item as reflected in

the firms books and itwont reflect the fair market value.

Books costs do not represent cash flows and thus are nottaken into account for economic analysis decisions exceptfor potential depreciation impacts for tax consequences.

Market price for financial assets such as stocks, landvalues.


Incremental Cost


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In economic analysis decisions, focus must be onincremental costs or those cost differences betweenalternatives.

If we need to compare between two equipments with sameannual maintenance fee, there is no incrementaldifference. Therefore maintenance fee can be excludedfrom the analysis.

But the one equipment annual maintenance is USD 500more than other equipment, then there is an obviousincremental cost difference, which then must beconsidered in the analysis between the three alternativeunits.


Changes in Cost


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g

Changes in costs occur for a number of reasons inthe economy.

Cost professionals must be conversant with thepotential for cost changes and their implications.

The most common cost changes concepts are:1. Inflation

2. Deflation3. Escalation

4. Currency Variation


Inflation


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The word inflation refers to a persistent rise in the general price level,as measured against a standard level of purchasing power.

The inflation does not occur by itself but must have a driving forcebehind it.

There are four effects that can result in inflation:

Money Supply influenced by the central bank of a country.

Exchange Rates by influencing the price of imported goods & services.

Demand-pull Inflation excessive amount of money chasing a limited goods.

Cost-push Inflation when product producers encounter higher costs.


Deflation


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Deflation is a decrease in the general price level over aperiod of time. Deflation is the opposite of inflation.

The same driving force of Inflation will causedeflation but in different direction.


Escalation


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Escalation is technique to accommodate price increases or decreases

during the life of the contract.

An escalation or de-escalation clause is incorporated into the contract so

that the purchaser will compensate the supplier in the event of pricechanges.

It will help to shield both the supplier and the purchaser from

unpredictable cost changes.

Without such clauses, suppliers would include contingency amounts.

Fixed Price Economical Price Adjustment Factor is a type of contract

where escalation technique will be used.


Currency Variation


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y

Due to the predominant Multi National Companieswho operates in different country and trades arehappening across the horizons, currency variation

plays a important role in economic cost analysis. For e.g., Financial assets held in one country can go

down if the country central bank devaluate thecurrency.

Protecting against currency variation is complicatedand can be accomplished through currency futureshedging or valuing contracts against very stablecurrencies, to cite two examples.


Governmental Cost Impacts


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p

The actions of the governmental units andjurisdictions can impose significant cost impact onthe firm.

Taxes, Economic Sanctions, Embargo are someexamples of governmental cost impacts to a firm.


Taxes


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Governments are most often maintained by the taxes they impose.

There are different types of taxes:

Income Tax

Property Tax

Inventory Tax

Employment Tax

Gross Receipts Tax

Sales Tax

VAT (Value Added Tax)


Effective Tax Rates and Marginal Tax Rates


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Effective Tax Rates

Actual income tax paid divided by net taxable income before taxes, expressed as a

percentage.

Marginal Tax Rates

The tax rate paid on the last dollar of one's income (Tax rate on the next dollar oftaxable income).


Investment Tax Credits
http://www.investorwords.com/2411/income_tax.htmlhttp://www.investorwords.com/4879/taxes.htmlhttp://www.investorwords.com/2400/income.htmlhttp://www.investorwords.com/2400/income.htmlhttp://www.investorwords.com/4879/taxes.htmlhttp://www.investorwords.com/2411/income_tax.htmlhttp://www.investorwords.com/2411/income_tax.htmlhttp://www.investorwords.com/2411/income_tax.html


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To encourage investment or economic activity,governments may give firms tax credits based on theirinvestments in a particular location.

Government may want to encourage the location of newplants in economically depressed areas and, therefore,promote this through investment tax credits includingabeyance on certain taxes such as property taxes.

JAFZA (Corporate taxes are not applicable for a period of50 years )

Investment on Non-conventional energy sources.


Depreciation and Depletion


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To encourage firms to invest in new plants and machinery, government oftenallow firms to depreciate their investment over time.

Thus depreciation technique will allow the firm to reduce its income by a setproportion per year with a depreciation write-off until the investment is fully

depreciated. The limits on investment depreciation write-off are prescribed by the

governmental tax code.

Depreciation thus should be not confused as s cash-flow, but rather an non-cashexpense that reduce taxable income.

Firms are allowed to depreciate based on original plant and equipment costs. Current and future inflation during the assets depreciation can not be taken into

account for these purposes.


Depletion


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Depletion is comparable to depreciation but it is usedfor natural resources.

Owners of natural resources like quarry, oil well, orstanding timber as examples can take depletionallowances based on the percentage of resources usedup in a given time period.


Depreciation Technique


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Standard Methods

Straight-Line (SL) method

Double-Declining Balance (DDB) method

Sum-Of-Years Digits (SOYD) method

Modified Accelerated Cost Recovery System (MACRS)

Units Of Production (UOP) method


Straight Line Depreciation


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Simple Method equal amount of depreciation everyyear.

Formula is D = (C-S) / N

D = Depreciation Charge

C = Asset Original Cost

S = Salvage Value, and

N = Asset Depreciable Life

Exercise: Find Depreciation Charge for an assetoriginal cost $10,000, 5-years life and $2900 residualsalvage value.


Double-Declining Balance Depreciation


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It applies constant depreciation rate to the assetsdeclining value.

Formula is D = (2/N) (C-BVt-1)

D = Depreciation Charge

C = Asset Original Cost

BV = Book Value at given Year, and

N = Asset Depreciation Life (Years)



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DDB: Asset $10,000, 5 Years, $2900 Residual Value

Year DDB Formula DDB Calculated

Amount

DDB Allowable

Depreciation

1 (2/5)($10000-0) $4000 $4000

2 (2/5)($10000-$4000) $2400 $2400

3 (2/5)($10,000-$6400) $1440 $700*

4 (2/5)($10,000-$7840) $864 $0

5 (2/5)($10,000-$8704) $518 $0

Total $9222 $7100


* An asset cannot be depreciated below its salvage value thus depreciatio

Sum-of-Years Digits Depreciation


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SOYD method allows depreciation to be taken at a faster rate than Straight Line

Depreciation.

SOYD method takes depreciation in any one year as the product of a fractional

value times the total original depreciable value.

Formula is Dr = (C S) * [(2 ( N r + 1 )) / (N ( N + 1 )) ]

Dr = depreciation charge for the rth year

C = asset original cost

S = Salvage value

N = remaining asset depreciable life (years) r = rthYear



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SOYD Amount

Year SOYD Formula SOYD Calculated

Amount

1 (5/15)($10,000-$2900) $2367

2 (4/15)($10,000-$2900) $1893

3 (3/15)($10,000-$2900) $1420

4 (2/15)($10,000-$2900) $ 947

5 (1/15)($10,000-$2900) $ 473

Total $ 7100


Modified Accelerated Cost Recovery System


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The MACRS is unique to United States Tax Code.Depreciation under this MACRS method is based onoriginal asset cost, asset class, asset recovery period

and asset in service date. Asset classes aredifferentiated based on 3-year, 5-year, 7-year, 10-yearand other property lives, depending on asset type.

Depreciation rates are set by percentages allowedunder U. S. Tax Code.


Units of Production Depreciation


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The UOP method is utilized when depreciation is more accurately basedon usage instead of time. The UOP method is particularly useful when anasset encounters variable demand.

A piece of construction equipment may be used:

First Year 1200 Hrs

Second Year 2400 Hrs

Third Year 600 Hrs

The UOP method recognizes that the equipment wears out based on useand, therefore, is a more accurate barometer than years.


Economic Analysis Techniques


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There are a variety of economic analysis techniques available to enableaccurate choices between competing alternatives. They are:

1. Net present worth

2. Capitalized cost

3. Annual cash flow analysis

4. Rate of return analysis

5. Benefit-cost ratio analysis, and

6. Payback period



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Net present worth method


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A common basis is needed when comparing alternatives.Alternatives typically will have different costs andbenefits over the analysis period. The net present worth

(NPW) method provides the platform to resolvealternatives into equivalent present consequences. A firm is evaluating the potential purchase of one of two pieces of

equipment. Unit A has a purchase price of $10,000 with a four-yearlife and zero salvage value. Annual maintenance costs are $500 per

year. Unit B has a purchase price of $20,000 with a twelve-year lifeand $5,000 salvage value. In Year 1, maintenance costs are zero. InYear 2, maintenance costs are $100 and increase by $100 per yearthereafter. The firms cost of capital is 8%.


Net present worth method


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NPW Unit A:

= $10,000 + $10,000(P/F,8%,4) + $10,000(P/F,8%,8) + $500 (P/A,8%,12)

= $10,000 + $10,000(0.7350) + $10,000(0.5403) + $500 (7.536)

= $26,521

NPW Unit B: = $20,000 + $100(P/G,8%,12) + $5,000(P/F,8%,12) - $100

= $20,000 + $100(34.634) + $5,000(0.3971) - $100

= $21,349

Analyzing costs, lower NPW Unit B is preferable. Analyzing benefits, higher NPW Unit A is preferable.


Capitalized Cost Method


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Capitalized cost represents the present sum of moneythat needs to be set aside now, at some interest rate, to

yield the funds required to provide the service

indefinitely. Formula is A=PI

A bridge is build for $10,000,000 and will have maintenance cost of$200,000 per year. At 6 percent interest, what is the capitalizedcost of perpetual service?

Present Value = $10,000,000

Ongoing cost = $200,000

Capitalized Cost = $10,000,000 + ($200,000)/.06 = 13,333,333


Equivalent Uniform Annual Cost or Benefit


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For some types of analysis, it may be preferable to resolve the comparison toannual cash flow analysis. The comparison may be made on the basis ofequivalent uniform annual cost (EUAC), equivalent uniform annual benefit(EUAB) or on the EUAB-AUAC difference.

Annualized sum of all relevant costs. It is like the amount of an installmentloan payment.

Unit A Unit B

Initial Cost $20,000 $15,000

Salvage Value $3,000 $2,000

Life Year 10 Years 5 Years Cost of Capital 10% 10%


EUAC Solution


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Formula is (P S) (A/P, I, n) + SI

EUAC (A) = ($20,000 - $3000) (A/P, 10%, 10) +3,000(0.10)

= ($17,000) (0.1627) + $300

= $2765.90 + $300 = $3065.90

EUAC (B) = ($15,000-$2,000) (A/P, 10%, 5) +

$2,000(0.10)= ($13,000) (0.2638) + $200

= $3629.40


Right Choice

Rate of Return Analysis


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Many organizations in making investment choicesoften set hurdle rates. The hurdle rate is the

benchmark rate of return that a capital investment

decision must achieve to be acceptable.

A rate of return (ROR) is computed from theprojected cash flows of the project.

Rate of return (ROR) or return on investment (ROI),or sometimes just return, is the ratio of moneygained or lost on an investment relative to theamount of money invested.


Rate of Return Analysis


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Assume that in the comparison between Unit A and Unit B (each with a1-year life) that the cost of $20,000 for Unit A versus a $10,000 cost forUnit B also results in an incremental benefit of $15,000 for Unit A ascompared to Unit B. If the organization has a hurdle rate of 20 percent

for capital projects, which alternative a better choice. NPW of the cost is set equal to the NPW of the benefit.

The NPW cost of Unit A versus Unit B is $10,000 ($20,000-$10,000).The NPW of the Unit A Unit B benefit is $15,000.

ROR NPW Cost = NPW Benefit$10,000 = $15,000 (P/F,I,1)

$10,000/$15,000 = 0.667


Benefit-Cost Ratio Analysis Method


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Benefit Cost (B/C) Ratio analysis involves the simple comparison between benefits and costs ofa proposed action. Benefits are placed in the numerator and costs are placed in thedenominator. If the ratio of benefits to costs is greater than one, project is viable. Comparisonscan be made between projects to select those projects with highest B/C ratio.

Its a simple comparison between benefits and costs of a proposed action.

For e.g.,Project A Project B

NPW Benefit $1,500,000 $2,000,000

NPW Cost $1,200,000 $1,700,000

B/C 1.25 1.17

On the basis of the above B/C analysis, both projects A and B have a positive B/C ratio, but

Project A would be selected as its 1.25 ratio is greater than the Project Bs 1.17 ratio.


Pay Back Period Method


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Payback period in business and economics refers to theperiod of time required for the return on an investmentto "repay" the sum of the original investment.

Very simple method and can prove inaccurate. A project with a payback period of three years may be

selected over a similar project of five year pay backperiod. Differences in the timing of cash flows are notconsidered nor are benefits and costs beyond the pay

back period. For example, a $1000 investment which returned $500

per year would have a two year payback period.



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Activity-Based Cost Management

Chapter 8

Introduction


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In a business organization, Activity-based costing (ABC)is a method of allocating costs to products and services.It is generally used as a tool for planning and control.

Traditionally cost accountants had arbitrarily added abroad percentage onto the direct costs to allow for theindirect costs.

However as the percentages ofoverhead costs had risen,this technique became increasingly inaccurate because

the indirect costs were not caused equally by all theproducts.

Fig 8.1


ABC
http://en.wikipedia.org/wiki/Accountanthttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Overhead_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Indirect_costhttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Direct_costhttp://en.wikipedia.org/wiki/Accountant


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More accurate cost management methodology

Focuses on indirect costs (overhead)

Traces rather than allocates each expense category tothe particular cost object.

Makes "indirect" expenses "direct"


ABC Basic Premise


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Cost objects consume activities

Activities consume resources

This consumption of resources is what drives costs Understanding this relationship is critical to

successfully managing overhead


When to use ABC


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Overhead is high

Products are diverse: complexity, volume, amount ofdirect labor

Cost of errors are high

Competition is stiff


ABC


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For example, one product might take more time inone expensive machine than another product, butsince the amount of direct labor and materials might

be the same, the additional cost for the use of themachine would not be recognized when the same

broad 'on-cost' percentage is added to all products.

Consequently, when multiple products sharecommon costs, there is a danger of one productsubsidizing another.


Methodology


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Direct labor and materials are relatively easy to trace directly to

products, but it is more difficult to directly allocate indirect costs to

products.

Where products use common resources differently, some sort of

weighting is needed in the cost allocation process. The measure of the

use of a shared activity by each of the products is known as the cost

driver.

For example, the cost of the activity of bank tellers can be ascribed to

each product by measuring how long each product's transactions takesat the counter and then by measuring the number of each type of

transaction.


Limitations
http://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driverhttp://en.wikipedia.org/wiki/Cost_driver


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Even in activity-based costing, some overhead costsare difficult to assign to products and customers, forexample the chief executive's salary.

These costs are termed 'business sustaining' and arenot assigned to products and customers becausethere is no meaningful method.

This lump of unallocated overhead costs mustnevertheless be met by contributions from each ofthe products, but it is not as large as the overheadcosts before ABC is employed.


ABC Steps


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1. Identify activities

2. Determine cost for each activity

3. Determine cost drivers4. Collect activity data

5. Calculate product cost


1. Identify activities


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Set-up

Machining

Receiving Packing

Engineering


2. Determine activity cost


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Set-up $10,000

Machining $40,000

Receiving $10,000 Packing $10,000

Engineering $30,000


3. Determine Cost Drivers


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Set-up: Number of Setups

Machining Machining Hours

Receiving Number of Receipts

Packing Number of Deliveries

Engineering Engineering Hours



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4. Collect Activity Data

Activity Cost Product A $ Product B $

Setup 10,000 1 2,500 3 7,500

Machining 40,000 100 2,000 1900 38,000

Receiving 10,000 1 2,500 3 7,500

Packing 10,000 1 2,500 3 7,500

Engineering 30,000 500 15,000 500 15,000

24,500 75,500


Product Cost Calculation


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Overhead for Product A:

$24,500:100 = $245

Overhead for Product B:

$75,500:1900 = $ 39.74


Product Cost TCA vs. ABC


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Cost for Product A:

Overhead: TCA: $50.00 ABC: $245.00

Direct Cost $20.00 $20.00

Total $70.00 $265.00

Cost for Product B:

Overhead: TCA: $100.00 ABC: $39.74

Direct Cost: $40.00 $40.00

Total $140.00 $79.74


ABC vs. TCA


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ABC is more accurate cost management system thanTraditional Cost Accounting

Traditional Cost Accounting is unable to calculate

the "true" cost of a product



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END OF SECTION 1


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