1

Some General Key Concepts: Classifying Costs

Types of Costs
• Fixed Costs & Variable Costs
• Marginal Costs & Average Costs
• Sunk Costs & Opportunity Costs
• Recurring & Non-recurring Costs
• Incremental Costs
• Cash Costs & Book Costs
• Life-Cycle Costs
 Marginal Costs and Average Costs

Marginal Costs: The variable cost for one more

unit of output
 Capacity Planning: Handling excess capacity
 Basis for last-minute pricing

Average Costs: Total cost divided by the total

number of units produced.
 Basis for normal pricing
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Total vs. Average vs. Marginal Cost

F = $50 v =$1 Cost vs. Number of Units
Number Total Average Marginal
80
1 $51 51.00 $1
2 52 26.00 1 70
3 53 17.67 1
4 54 13.50 1 60
5 55 11.00 1
50
6 56 9.33 1 Total

C ost
7 57 8.14 1 40 Average
8 58 7.25 1 Marginal
9 59 6.56 1 30

10 60 6.00 1
20
11 61 5.55 1
12 62 5.17 1 10
13 63 4.85 1
14 64 4.57 1 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
15 65 4.33 1
16 66 4.13 1 Number of Units
17 67 3.94 1
18 68 3.78 1
19 69 3.63 1
20 70 3.50 1
 4

Marginal Cost
• This is the correct value to look at in deciding
whether to increase production
It’s the extra cost we would have to pay!
• In our example:
Marginal cost << Average cost
High fixed cost promotes Economies of Scale
• Marginal cost can be > Average cost:
Payment of O/T after certain level
__________________________?
 5

Economies of Scale
• It costs less per unit to produce at higher levels
of output
Fixed costs can be spread over a larger number of
units
Production or operating costs do not increase linearly
with output levels
Quantity discounts are available for material
purchases
Operating efficiency increases as workers gain
experience
 6

Some General Key Concepts: Classifying Costs

Types of Costs
• Fixed Costs & Variable Costs
• Marginal Costs & Average Costs
• Sunk Costs & Opportunity Costs
• Recurring & Non-recurring Costs
• Incremental Costs
• Cash Costs & Book Costs
• Life-Cycle Costs
 7

Sunk Costs
• Sunk cost is any cost that occurred in the past…
Cannot be changed/reversed by future decision or action
• Sunk costs are irrelevant for making decisions…
They are irrelevant when estimating future costs and revenues
related to an alternative…
Why?:
Decisions should be made on the basis of differences
between choices (Identical factors cancel out)
Sunk costs remain constant regardless of what you do
Should be ignored in your choice!
(Except if they affect tax liability and depreciation)
• This principle is difficult to apply… Why??
 8

Sunk Costs
• Examples
Purchasing price of current equipment in deciding new
equipment (except for capital gain/loss consideration)
Deciding whether to finish a half-completed project
(…ignore its past, “doomed to extinction” costs!)
Watching a bad movie!! (How long would you watch a
terrible movie?... Ignore the $5!!)

• How should you consider sunk costs?

 To learn what went wrong! … so you can avoid that in
future decisions
Sunk Costs
& Opportunity Costs
 Opportunity Costs:
 The benefit foregone by selecting one alternative
over another
Cost or value of the foregone opportunity
Value of the best rejected alternative
“What we give up" from "the road not taken.
It is hidden or implied…
Existing (‘old’) equipment in replacement analysis

http://eco.unne.edu.ar/contabilidad/costos/profesores/Costos2002.htm
Example: Distributor of electric pumps…
What to do with lot of old pumps purchased 3 years ago becoming obsolete

 Purchase Price of Old Pumps $7,000 (Sunk)

 Storage Costs of Old Pumps $1,000 (Sunk)
 List Price of Old Pumps (3 yrs ago) $9,500 (Irrelevant)
 Offer of Old Pumps (2 yrs ago) $5,000 (Irrelevant)
 Current Price of Old Pumps $3,000
 List Price of New Pumps $12,000 (Irrelevant,
unless this
becomes
actual price)

What is relevant here?

 11

Some General Key Concepts: Classifying Costs

Types of Costs
• Fixed Costs & Variable Costs
• Marginal Costs & Average Costs
• Sunk Costs & Opportunity Costs
• Recurring & Non-recurring Costs
• Incremental Costs
• Cash Costs & Book Costs
• Life-Cycle Costs
Recurring Costs and Non-recurring Costs
• Recurring Costs: Repetitive… occur when a firm
produces similar goods and services on a
continuing basis
Annual maintenance expenses
• Non-recurring Costs: Not repetitive [even though
the total expenditure may be cumulative over a
period of time]
Typically involve developing or establishing a
capability or capacity to operate (e.g., cost for
real estate, construction costs of new plant
plant, installing new machine)
 13

Some General Key Concepts: Classifying Costs

Types of Costs
• Fixed Costs & Variable Costs
• Marginal Costs & Average Costs
• Sunk Costs & Opportunity Costs
• Recurring & Non-recurring Costs
• Incremental Costs
• Cash Costs & Book Costs
• Life-Cycle Costs
Incremental Costs: Difference in costs
between two alternatives
Example: Choosing between Model A & B
Incremental
Cost Items Model A Model B
Cost (B vs. A)
Purchase Price $10,000 $17,500 $7,500

Installation Costs 3,500 5,000 1,500

Annual Maintenance 2,500 750 -1,750

Annual Utility 1,200 2,000 800

Disposal Cost 700 500 -200

 15

Some General Key Concepts: Classifying Costs

Types of Costs
• Fixed Costs & Variable Costs
• Marginal Costs & Average Costs
• Sunk Costs & Opportunity Costs
• Recurring & Non-recurring Costs
• Incremental Costs
• Cash Costs & Book Costs
• Life-Cycle Costs
Cash Costs versus Book Costs
• Cash Costs: Costs that involve money/cash transactions
Salaries, Interest payments, Taxes, etc.
• Book Costs*: Costs that that do not involve money/cash
transactions
Depreciation (charged for the use of assets, such as plant and equipment)
An acquisition cost of $10,000 for a property, as reflected on
accounting statements, includes: purchase price, installation, and
indirect costs such as interest during construction.
• This book cost of $10,000 is a historical fact; it is not a measure
of current value or of replacement cost, either of which may be
greater or less than $10,000.

* “Costo contable”= aquel que se refleja en los estados financieros sin

que haya un desembolso monetario por él.
 17

Some General Key Concepts: Classifying Costs

Types of Costs
• Fixed Costs & Variable Costs
• Marginal Costs & Average Costs
• Sunk Costs & Opportunity Costs
• Recurring & Non-recurring Costs
• Incremental Costs
• Cash Costs & Book Costs
• Life-Cycle Costs
 Life-Cycle Costs

Life-Cycle Costs: 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 needs or wants (the requirements)
and ends with the retirement and disposal
activities.
Phases of Life Cycle
1. Need 2.Conceptual 3. Detailed 4. Production 5.Operational 6. Decline/
Assessment Design Design /Construction /Use Retirement

Requirements Impact Allocation of Production of Distribution of Phase Out

Analysis Analysis Resources Goods/ Goods/
Services Services
Overall Proof of Detailed Building of Maintenance/ Disposal
Feasibility Concept Specifications Supporting Support
Study Facilities
Conceptual Prototype/ Component/ Quality Retirement
Design Breadboard Supplier Control/ Planning
Planning Selection Assurance
Development/ Production Operational
Testing Planning Planning

Detailed
Design
Planning
 Cumulative Life-Cycle Costs
Committed and Spent
100%
90%
80%
70% Life-Cycle Costs
60% Committed
50%
40% Life-Cycle Costs
30% Spent
20%
10%
0%
Need Conceptual Detailed Production Operational Decline/
Assessment Design Design /Construction /Use Retirement
Cumulative Life-Cycle Costs Cost / Ease of Design Changes
in Product Life Cycle
Committed and Spent
100%
90%
Cost of
80%
Design
70% Life-Cycle Costs Changes
60% Committed
50%
40% Life-Cycle Costs Ease of
30% Spent Design
20% Changes
10%
0%
Need Conceptual Detailed Production Operational Decline/
Assessment Design Design /Construction /Use Retirement
 22

Recapitulating …
 Key Principles of Economic Analysis
 Categories of Costs
Estimating Engineering Costs
 Sources of Costs Estimates
 General Approaches for Estimating Cost
 Cost Estimating Models
 Financial Mathematics
Types of Costs
 Fixed Costs & Variable Costs
 Marginal Costs & Average Costs
 Sunk Costs & Opportunity Costs
 Recurring & Non-recurring Costs
 Incremental Costs
 Cash Costs & Book Costs
 Life-Cycle Costs

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Estimating Engineering Costs…

Costs…
Past/Historical?
Current?
Future/Estimated?