Cost Classifications

In engineering economic analysis, various types of costs must be considered, each differing in frequency, size, and impact. This section defines key cost categories and how they should be treated:

Fixed Costs

• Do not change with activity level (within a certain range).

• Examples: Insurance, salaries, taxes, license fees, loan interest.

• May change if operations expand or shut down significantly.

Variable Costs

• Change with output or activity level.

• Examples: Materials and labor per unit.

• Also called avoidable costs.

Incremental Costs

• The additional cost or revenue from a small change in output.

• Relevant in "go–no go" decisions (e.g., whether to take on a new trip or project).

• Can be hard to estimate accurately in practice due to multiple influencing factors.

Direct Costs

• Costs easily traceable to a specific product, service, or activity (e.g., materials and labor for making scissors).

Indirect Costs (Overhead or Burden)

• Harder to assign directly; typically allocated using formulas (e.g., tools, maintenance, electricity, supervision).

Standard Costs

Predetermined costs per unit based on expected labor, material, and overhead.

Used for:

• Estimating future costs

• Measuring performance

• Bidding

• Valuing inventory

Cash Cost vs. Book Cost

Cash Costs

Actual payments that result in cash outflows (relevant for economic analysis).

Book Costs

• Non-cash accounting entries like depreciation that reflect past spending.

• Only relevant when they impact tax liabilities.

Sunk Cost

• A sunk cost is a past, irrecoverable expense that should not influence future decisions.

• Example: A $40 down payment lost on a motorcycle doesn't affect which new one to buy—only future cash outflows matter.

• Key Insight: Sunk costs are irrelevant to comparing future alternatives, except for possible tax implications.

Opportunity Cost

• An opportunity cost is the value of the best alternative foregone when a resource is used in a particular way.

• Example: Choosing school over work incurs a $25,000 opportunity cost ($5k spent + $20k income lost).

• In decisions like equipment replacement, the resale value of the current asset is treated as the true cost of keeping it.

Life-Cycle Cost

• Life-cycle cost includes all costs associated with a product, structure, or system over its entire lifespan.

• Two phases:

• Acquisition: Defining needs, designing, testing, and implementing.

• Operation: Use, maintenance, and disposal.

• Most cost-saving potential lies in early design stages, where design choices have a big impact on future costs.

• Emphasis is on long-term cost optimization through engineering and economic analysis at all stages.