CHAPTER 7

Cost Estimation

Review

• General Problem Solving Skills• Moving Money through Time

(Equivalence Models)• Developing Estimates of Future

Cash Flows• Using Cash Flows to Compute

Various Measures of Economic Merit before and after tax

• Chapter 2• Chapter 3

• Chapter 7

• Chapter 4, 5, and 6

Cost Estimation

• What is estimating? – A forecast, a best guess, a projection into the future

• For the most part, Engineers generally have the responsibility of cost estimation

• Future costs are very critical to the analysis of a project

• Revenue generation generally comes from marketing or sales areas

Applications

• What is the purpose of estimating?– quoting, bidding, or evaluating bids;

– profitability analysis;

– basis for make versus buy decisions;

– investment justification;

– basis for comparing manufacturing methods;

– basis for cost reduction;

– planning new products and services;

• All these involve developing cash flows for feasible alternatives

Costs to Estimate• What costs are to be estimated?

– First cost elements • Equipment cost;

• Delivery charges;

• Installation costs;

• Insurance costs (premiums);

• Training of personnel for equipment use.

• The first important cost– Given the interest rate and the estimated life of the

asset• Calculate the Capital Recovery Costs

Annual Operating Cost Estimation

• Estimate the AOC using:– Direct Labor Costs– Direct materials costs– Periodic maintenance costs– Rework and rebuilt– Other costs could be

• On-line testing and calibration;

• “Proofing runs before actual production.

Work Breakdown Structure (WBS)• The WBS technique organizes activities into a

hierarchical structure based on either functional or physical categories

• See Figures 7-2 and 7-3• WBS - Organizational Schemes• Functional

– Logistical Support, Project Management, Marketing, Engineering, System Integration

• Physical– Products, Outputs, or Parts that make up the structure

WBS-Tabular Format

1.0 Commercial Building Project1.1 Site Work and Foundation

1.1.1 Site Grading

1.1.2 Excavation

1.1.3 Sidewalks/Parking

1.1.4 Footing/Foundation

1.1.5 Floor Slab

1.2 Exterior

1.2.1 Framing

1.2.2 Siding

1.2.3 Windows

1.2.4 Entrances

1.2.5 Insulation

1.3 Interior

1.3.1 Framing

1.3.2 Flooring/Stairways

1.3.3 Walls/Ceilings

1.3.4 Doors

1.3.5 Special Additions

Cost Estimation Approaches• Bottom-Up Approach

– Treats the final cost as an independent (output) variable and the associated costs as input or dependent variables

• Top-Down Approach– Treats the competitive cost as an input variable and

the associated cost estimates as the output variables– Also called Design-to-Cost Approach

Two Cost Estimating Approaches

Bottom-Up Approach

• Treats the final cost as an independent (output) variable and the associated costs as input or dependent variables.– Cost components are first identified;– Cost elements are estimated;

• Price = DC + TIDC + Profit

• Traditional costing approach;• Applied in industries where competition is not the

dominant factor in pricing the product or the service

Top-Down Approach• Treats the competitive cost as an input variable and the

associated cost estimates as the output variables.• Applied in the early stages of new or enhanced product

design• Price estimates are conducted to set “target” values• Detailed design and equipment needs are not yet

defined• Becoming more popular especially in high competition

markets• Places greater emphasis on the accuracy of the

estimation process• Common practice in Eastern cultures (Japan and other

Asian countries)

Accuracy of Estimates• NO estimate is intended to be “exact”• But must be reasonable and accurate enough to provide

a robust economic analysis.• In Preliminary Design Phase:

– Estimates are viewed as “first cut” estimates.

– Serve as inputs to the project initial budget.

– The “unit method” is often applied here

• Accepted Range of Accuracy

– Per Unit approaches should fall into the 5% to 15% range

for total costs

– Estimates outside of the 15% range are not reliable!

Cost Estimation Techniques

• Expert Opinion;

• Past experience in the field

• Cost Indexes where available;

• Cost Estimating Relationships (forms of regression

analysis based upon historical data)

• Combinations of the above.

Cost Index

• Cost Index is a ratio of a cost NOW to some cost back in time.

• The index is a dimensionless number.• Example: The Consumer Price Index (CPI)• Cost Index Notation

– IN = Index for some current year, N

– Ik = Index for some base year, k

– Ck = cost of some item during base year

CN = Ck ( IN / Ik )

– CN = cost of the item during the current year

Sources:

• Chemical Engineering plant cost index;• Engineering News Record;• Marshall & Swift equipment cost index;• Many others……• Most are web-based but require a subscription fee to

access detailed values

Index Example• Need to estimate skilled labor for a construction

project;• 5 years ago the cost was documented to be $360,000.• Skilled labor index then was 3,496.27.• Today the index is 4,038.44.• What is the estimated labor cost today based upon this

information?

• CN = Ck ( IN / Ik )

Warnings to Heed

• For manufacturing and servicing industries tabulated cost indexes are not readily available

• Cost indexes may vary with the region of the country

• Cost indexes are very sensitive over time to technological changes.

Development of Cost Index-Example• A manufacturing engineer with Hughes Industries is

interested in estimating the cost of plant expansion. Two items used in the manufacturing process are A and 2. Consulting through Purchasing Department, he found the following historical data. Make the first quarter of 2001 the base period, and determine the cost indexes using a basis of 100.Year 1999 2000 2001 2002

Quarter Q1 Q2 Q1 Q2 Q1 Q2 Q1

--------------------------------------------------------------------------------------------------

Item A, $/unit 57.00 56.90 56.90 56.70 56.60 56.40 56.25

Item B, $/Unit 446 450 455 575 610 625 635

Solution• For each item, the index (IN/Ik) is calculated with the firs-

quarter 2001 cost used for the Ik value Year 1999 2000 2001 2002

Quarter Q1 Q2 Q1 Q2 Q1 Q2 Q1

--------------------------------------------------------------------------------------------------

Item A cost index 100.71 100.53 100.53 100.17 100.00 99.65 99.38

Item B cost index 73.11 73.77 74.59 94.26 100.00 102.46 104.10

• [((56.60-56.60)/56.60 )*100]+100

The Unit Technique• Unit Method:

– Popular, Very preliminary in nature, Multiply the number of units times a per unit cost factor.

• Examples:– Cost per operating mile (autos, trucks, etc.),

Cost of construction (per sq. foot), Cost per mile (highways, cable, etc.)

The Factor Technique• An extension of the unit method• Originally developed for estimating total plant costs;• Identify the major equipment items, then multiply by

certain factors;• Sum of products of component quantities and

corresponding unit costs plus component costs estimated directly

C = dCd + mfmUm

C = cost being estimated

Cd = cost of d estimated directly

fm = cost per unit of m

Um = number of units of m

Example

• Estimate the cost of a house consisting of 2,000 sq, two porches, and a garage. Using unit factor of $50 per sq, and $5,000 per porch and $8,000 per garage.

C = dCd + mfmUm

• C=($5,000*2)+8000+($50*2000)=$118,000

Cost Estimating Relationships ( CER )

• CER’s use design variables to predict costs.

• CER’s are more quantitative in nature than cost indexes.

• Developed from statistical approaches;– Usually linear or non-linear regression models.

• A common model: Cost-Capacity Model

• A model that relates the cost of an asset or activity to its

capacity

• Called also power-sizing

The Power-Sizing Technique

• Also referred to as exponential model• Used for costing plants and equipment• Recognizes that cost varies as some power of the

change in capacity or size• Example• (CA / CB) = (SA / SB)X

• CA = CB(SA / SB)X

CA = Cost of plant A CB = Cost of plant B

SA = Size of plant A SB = Size of plant BX = cost-capacity factor (reflects economies of scale)

The Exponent in the CCE - x• Normally 0 <x<1• For x < 1 the economies of scale are applied.• For x = 1, the model is linear.• For x > 1, a larger size is expected to be more costly than

a linear model.• If x is unknown, common to assume x = 0.6• The Chemical Engineering area has well documented

CCE parameters.• Other sources:

– Plant Design and Economics for Chemical Engineers;– Chemical Engineers Handbook;– EPA publications;– Equipment companies.

The Learning and Experience Technique• Learning curve is a mathematical model that explains

increased worker efficiency and improved performance from repetitive production

• Most learning curves are based on the assumption that the number of input resources needed decreases by a constant percentage each time the number of units produced doubles.

Zu = Kun

u = the output unit numberZu = # resource units to produce output unit u

K = # resource units to produce 1st output units = learning-curve slope parameter (decimal)n = log s / log 2

Example

• It has been determined that a 90% learning curve applies to a particular assembly operation. It takes 30 minutes to assemble the first unit. How many minutes are required to produce the 5th unit? the 30th unit?

• n = log (0.9) / log (2) = -0.152

• Z 5 = 30(5) -0.152 = 23.49 minutes

• Z 30 = 30(30) -0.152 = 17.89 minutes

Other Computations

• Tu = cumulative time to produce u units = K[un]

• Cu = cumulative average for u units = Tu/u

• Continuing our example,

• T5 = 30[1 -0.152 + 2 -0.152 + 3 -0.152 + 4 -0.152 + 5 -0.152 ] = 130.18 minutes

• C5 = T5/5 = 130.18/5 = 26.04 minutes per unit

Another Example• A construction Company designs and builds residential

family homes. The company is ready to construct, in sequence, 16 new homes of 2400 square feet each. The same basic design, with minor changes, will be used for each home. The successful bid for the construction materials in the first home is $64,800, or $27/square foot. The manger believes, based on past experience, that several actions can be taken to reduce material cost by 8% each time the number of homes constructed doubled. Based on this information, (a) what is the estimated cumulative average material cost per square foot for the first homes, and (b) what is the estimated material cost per square foot for the last 16th home?

Manufacturing Cost Estimating• Objective:

– To make a product that can be sold at a competitive price yet yields a reasonable profit.

• Determining Selling Price– To estimate the cost of a manufactured product, you need a

product design and process plan to compute direct labor hours and material costs

• A cost estimating worksheet or spreadsheet (e.g., Figure 8-5) is a useful tool for this.

Cost Accounting Overview• Costs incurred within a system are tracked by the cost

accounting system

• Cost accounting system accumulates:

– Material costs, Labor costs, and Indirect costs (overhead or factory

expense)

• And allocates these cost to defined cost centers.

• A difficult problem, when required, is to properly allocate the IDC’s to the various cost centers, departments, processes, and product lines.

• Cost centers do utilize a portion of the total indirect costs

• Thus, some allocation scheme needs to be applied to the cost centers

Traditional IDC Allocations

No. of inspectionsQuality Control

Number of accessesSoftware/Networks

Space occupiedBuilding Maintenance

Direct labor hours or DL cost.Personnel, Machine shop

$$ of Mtls; No. ordersReceiving/Purchasing

Space, direct labor hrsPower

Space, usage, outletsHeat, AC, light

Space occupiedTaxes

Allocation BasisCost Category

Summary• Cost estimation is not an exact science

• Estimates should be accurate enough to support robust engineering economy cost analysis

• Two Approaches: (Treat costs differently)– Bottom-Up and Top-Down

• Cost Indexes are used to estimate and update costs

• Cost Estimating– Cost-Capacity Equations,

• Cost estimation from design variables for material, equipment, and construction.

– Factor Method

• Used to estimate total plant costs.