When you leave school you will encounter many different ways (languages) of expr

Question

When you leave school you will encounter many different ways (languages) of expressing concepts you have likely already learned. This can be confusing but you can always try to refer what you are hearing to something you already know. Often it is just a simple matter of word definitions and nothing more.

One phrase you might encounter is “levelized costs”. Let’s connect this often used, “real world”, term to what we already know.

Let’s say you are producing 10,000 units of energy from a new facility. The facility costs $10,000,000 in capital (investment) to build and its annual cost is $250/unit to produce the energy. You expect the facility to have effectively an infinitely long life. What is the minimum price ($/unit) you should charge a buyer to obtain a 10% return on the $10 million investment?

Note: This cost is sometimes referred to as the “levelized cost” since it builds in the cost of capital (in this case at 10%) and spreads it out over future years.

Hint: Think this one through before you start calculating! Write the cost as the sum of a cost due to the capital (investment) per unit and the annual cost per unit.

Explanation / Answer

Ans:

Variable cost per unit = $250

Opportunity cost per unit = ( $10,000,000 * 10%) / 10000   

                                        = $1000,000 / 10000

                                        = $100

Minimum price($/unit) = variable cost + opportunity cost

                                    = $250 / unit + $100 / unit

                                     = $350 / unit

   Hence the minimum price to be charged is $350/unit.

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