Engineering Economic Analysis

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Engineering Costs 33

cost might be:

Anopportunity costis the benefit that isforgoneby engaging a business resource in a

chosen activity instead of engaging that same resource in the forgone activity.

As an example, suppose that friends invite a college student to travel through Europe

over the summer break. In considering the offer, the student might calculate all theout-of-

pocketcash costs that would be incurred. Cost estimates might be made for items such as

air travel, lodging, meals, entertainment, and train passes. Suppose this amounts to $3000

for a to-week period. After checking his bank account, the student reports that indeed he

can afford the $3000 trip. However, thetruecost to the student includes not only hisout-

of-pocketcash costs but also hisopportunity cost.By taking the trip, the student is giving

up theopportunityto earn $5000 as a summer intern at a local business. The student's

total cost will comprise the $3000 cash cost as well as the $5000 opportunity cost (wages

forgone)-the total cost to our traveler is thus $8000.

A distributor of electric pumps must decide what to do with a "lot" of old electric pumps purchased

3 years ago. Soon after the distributor purchased the lot, technology advances made the old pumps

less desirable to customers. The pumps are becoming more obsolescent as they sit in inventory.

The pricing manager has the following information.

Distributor's purchase price 3 years ago $ 7,000

Distributor's storage costs to date 1,000

Distributor's list price 3 years ago 9,500

Current list price of the same number of new pumps 12,000

Amount offered for the old pumps from a buyer 2 years ago 5,000

Current price the lot of old plimps would bring 3,000

Looking at the data, the pricing manager has concluded that the price should be set at $8000.

This is the money that the firm has "tied up" in the lot of old pumps ($7000 purchase and $tOOO

stor~$e), and it ~as re~soned th~t the c..oml?~.yshould at least recqy~r pup f;os}.Fu_rthermo.r~,

the pricing manager has argtied that an $8000 price would be $1500 less than the list price from

3 years ago, and it would be $4000 less than what a lot of new pumps would cost ($12,000 -

$8000). What would be your advice on price?

SOlUTlpN

~ - = " =

Let's look'more closely at each of the data items.

DistrIbutor's purchase price 3 years ago: This is a sunk cost that should not be considered

in setting the price today. 1:1

Distributor's storage costs to date: The storage costs for keeping the pumps in inventory

a],:esunk costs; that is, they have been paid. Hence they should not influence the pricing

decision.

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