Understanding Fixed, Variable, and Incremental Costs in Engineering Economics
Understanding Costs in Engineering Economics
Fixed Costs
Fixed costs are those that do not change with the level of operational activity within a specific production capacity range. Examples of fixed costs include:
- Insurance
- Real property or facilities taxes
- General administration
- General management or administrative salaries
- License fees
- Interest costs on borrowed capital
Variable Costs
Variable costs are those associated with operations that fluctuate in proportion to the total production volume or other activity level measures. When conducting an engineering economic analysis for a proposed change to an existing operation, variable costs are a primary focus for identifying differences between the current and proposed operations, assuming the activity range does not significantly change. For example, the costs of materials and labor used in producing a product or service are variable costs because their total amount changes with the number of units produced, even if the cost per unit remains constant.
Incremental Cost (or Incremental Revenue)
An incremental cost (or incremental revenue) is the cost (or income) resulting from a marginal increase in the production of one or more units of a system. Incremental costs are often associated with decisions that involve a modest change in the level of activity or production. For instance, the incremental cost per kilometer of driving a car might be $0.27, but this cost can vary based on factors such as the total distance driven during the year (within a normal operating range), the expected distance of the next long trip, and the vehicle’s age. Similarly, one might consider the incremental cost of producing a barrel of oil or the incremental cost to the state for educating a student.
What is Engineering Economics?
Engineering economics is a discipline focused on the economic aspects of engineering. It involves the systematic evaluation of the costs and benefits of proposed technical projects.
Engineering economics addresses the monetary implications of decisions made by engineers in a company striving for profitability in a competitive market.
It combines technical analysis with an emphasis on economic factors to aid in decision-making.
Principles of Engineering Economics
- Develop Alternatives: Identify and create various potential solutions.
- Focus on the Difference: Concentrate on the distinctions between alternatives.
- Use a Consistent Viewpoint: Maintain a uniform perspective throughout the analysis.
- Use a Common Unit of Measurement: Employ a standard unit for comparison.
- Consider Relevant Criteria: Take into account all pertinent factors.
- Make Uncertainty Explicit: Acknowledge and address uncertainties.
- Revisit Decisions: Review and reassess decisions periodically.
Cost Classifications
Direct costs are those that can be directly and reasonably measured and assigned to a specific productive activity or job. The costs of labor and materials directly associated with production, service, or construction are direct costs. For example, the materials needed to make a pair of scissors are a direct cost.
Indirect costs are those that are difficult to attribute or assign to a specific productive activity or work. This term generally refers to cost types where direct assignment to a specific product would require excessive effort. For example, the costs of common tools, general supplies, and plant equipment are considered indirect costs. Manufacturing overhead costs are those required to operate the plant but are not direct labor or direct material costs.
General Costs consist of plant operating costs that are not direct labor or direct material costs. Examples include electricity, general repairs, property taxes, and supervision.
Administrative and selling expenses are generally added to direct costs and overhead costs to determine a unit sales price for a product or service.