Costs: the engineer and costs
With ARS 600,000 of fixed costs per month and ARS 100 of contribution per unit, you must sell 6000 units to avoid a loss. Selling 8000, a 10 % increase in sales raises profit by 40 %: the operating leverage is 4.
01Classifying costs
A cost is the value of the resources consumed to produce. According to how they vary with volume, they are fixed —rent, overhead salaries, depreciation, which do not change with the quantity produced within a given range— or variable —materials, components, process energy, which grow with each unit—. According to whether they can be assigned to a product, they are direct —the components of a board, the assembly time— or indirect —maintenance, supervision, quality—, which are allocated using some criterion.
| Element | In an electronic unit |
|---|---|
| Direct materials | Components, board, cabinet, cables, packaging |
| Direct labor | Assembly, soldering, testing, from the standard time and the hourly cost |
| Manufacturing overhead | Machine depreciation, energy, maintenance, supervision, quality |
| Selling and administrative expenses | Sales, warranties, offices |
In absorption costing the product bears a share of the fixed manufacturing costs; in variable costing only the variable ones, and the fixed ones are treated as a period cost. The second is better for making decisions, because it does not hide how the result changes with volume.
02Contribution margin and break-even point
Each unit sold at price \( p \) with variable cost \( c_v \) contributes a contribution margin \( p - c_v \) to cover the fixed costs \( CF \) and, after that, to yield profit. The volume at which profit is zero is the break-even point:
The revenue (blue) and the total costs (orange) of an equipment manufacturer in a month, as a function of the units sold. The green zone is profit and the red one, loss; the yellow dot is the expected sales.
03The engineer and costs
Most of the cost of a product is fixed at the design stage, long before it is manufactured: the choice of components, the number of board layers, the assembly technology, how easy it is to test and to assemble. Designing for manufacturing and testing, standardizing components, reducing variants and thinking about the cost of the whole life cycle —including warranties and recycling— are engineering decisions with economic consequences. The analysis of investments with cash flows, rates and present value is developed in Economics.
04In the laboratory
Calculate the materials cost of a laboratory board with distributor prices for 1, 100 and 1000 units.
With the standard assembly time and an assumed hourly cost, calculate the direct labor per unit.
Compare the cost of making a power supply in the laboratory with that of buying a commercial one, separating fixed and variable costs.
05Common mistakes
- Treating a fixed cost allocated per unit as variable. If production drops, the unit cost rises, because the fixed costs are spread over fewer units.
- Forgetting that fixed costs are fixed only within a range. Moving to two shifts or to another plant changes them abruptly.
- Looking only at the cost of components. Testing, warranties and rework can weigh as much as the materials.
- Setting the price by adding a percentage to the cost without looking at the market. The market sets the price; the cost says whether it is worthwhile.
06Self-assessment
What is the break-even point with CF = 600,000, p = 250 and cv = 150?
6000 units.
What profit does selling 8000 give?
\( 8000 \cdot 100 - 600\,000 = 200\,000 \) ARS.
What is the margin of safety?
25 %: sales can fall by a quarter before a loss is incurred.
What happens to the break-even point if the price rises to 300?
It drops to 4000 units, because the contribution becomes ARS 150.
07Further reading
- Charles T. Horngren, Srikant M. Datar and Madhav V. Rajan. Cost Accounting: A Managerial Emphasis. Pearson. (Spanish edition: “Contabilidad de costos: un enfoque gerencial”.) The classification of costs, costing and cost-volume-profit analysis.
- Leland Blank and Anthony Tarquin. Engineering Economy. McGraw-Hill. (Spanish edition: “Ingeniería económica”.) The bridge between costs and investment analysis.
- Geoffrey Boothroyd, Peter Dewhurst and Winston Knight. Product Design for Manufacture and Assembly. 3rd ed., CRC Press, 2011. How design fixes the cost of manufacturing and assembling.