Engineering Economy

Lecture 3
Cost Estimation Techniques Chapter 3
Money Time Relationships and Equivalence Chapter 4

Engineering Economy
Results of cost estimating
are used for a variety of purposes.
Setting selling prices for quoting, bidding, or
evaluating contracts.
Determining if a proposed product can be
made and distributed at a profit.
Evaluating how much capital can be justified
for changes and improvements.
Setting benchmarks for productivity
improvement programs.

Engineering Economy
The two fundamental approaches:
Top-down uses historical data from similar
projects. It is best used when alternatives are
still being developed and refined.
Bottom-up is more detailed and works best
when the detail concerning the desired output
(product or service) has been defined and
clarified.

Engineering Economy
Integrated cost estimation approach
The integrated cost estimation
approach has three major
components.
Work breakdown structure (WBS)
Cost and revenue structure (classification)
Estimating techniques (models)

Engineering Economy
Work Breakdown Structure (WBS)
A basic tool in project management
A framework for defining all project work
elements and their relationships, collecting
and organizing information, developing
relevant cost and revenue data, and
management activities.
Each level of a WBS divides the work
elements into increasing detail.

Engineering Economy
A WBS has other characteristics.

Both functional and physical work elements

are included.
The content and resource requirements for
a work element are the sum of the
activities and resources of related
subelements below it.
A project WBS usually includes recurring
and nonrecurring work elements.

Engineering Economy
Cost and Revenue Structure
Used to identify and categorize the costs
and revenues that need to be included in
the analysis.
The life-cycle concept and WBS are
important aids in developing the cost and
revenue structure for a project.
Perhaps the most serious source of errors
in developing cash flows is overlooking
important categories of costs and revenues.

Engineering Economy
Estimating Techniques

REMEMBER! The purpose of estimating is to develop

cash-flow projections—not to produce exact data about the
future, which is virtually impossible. Cost and revenue
estimates can be classified according to detail, accuracy, and
their intended use.

Order-of-magnitude estimates (±30%)

Semidetailed, or budget, estimates (±15%)
Definitive (detailed) estimates (±5%)

Engineering Economy
Accuracy of Estimation
The level of detail and accuracy of
estimates depends on:
time and effort available as justified by the
importance of the study,
difficulty of estimating the items in question,
methods or techniques employed,
qualifications of the estimator(s), and
sensitivity of study results to particular factor
estimates.

Engineering Economy
Sources for cost and revenue estimation
Accounting records: good for historical data, but
limited for engineering economic analysis.
Other sources inside the firm: e.g., sales,
engineering, production, purchasing.
Sources outside the firm: Government data,
industry surveys, trade journals, and personal
contacts.
Research and development: e.g., pilot plant, test
marketing program, surveys.

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Models that can be used in many types of estimates

Indexes
Unit technique
Factor technique

Engineering Economy
 Indexes, I, provide a means for
developing present and future cost and
price estimates from historical data.

k = reference year for which cost or price is known.

n = year for which cost or price is to be estimated (n>k).
Cn = estimated cost or price of item in year n.
Ck = cost or price of item in reference year k.
Indexes can be created for a single item or for multiple
items (eqs. 3-1, 3-2).
Example
In 2002 Acme Chemical purchased a large pump
for $112,000. Acme keys their cost estimating for
these pumps to the industrial pump index, with a
baseline of 100 established in 1992. The index in
2002 was 212. Acme is now (2010) considering
construction of a new addition and must
estimate the cost of the same type and size of
pump. If the industrial pump index is currently
286, what is the estimated cost of the new
pump?

Engineering Economy
The unit technique
Unit technique: widely known and understood.
A “per unit factor” is used, along with the appropriate
number of units, to find the total estimate of cost. An
often used example is the cost of a particular house.
Using a per unit factor of, say, $120 per square foot,
and applying that to a house with 3,000 square feet,
results in an estimated cost of $120 x 3,000 =
$360,000.
This techniques is useful in preliminary estimates, but
using average costs can be very misleading.

Engineering Economy
The factor technique is an extension of the
unit technique where the products of
several quantities are summed and then
added to components estimated directly.

C = cost being estimated

Cd = cost of the selected component d estimated directly
fm = cost per unit of component m
Um = number of units of component m
Parametric Cost Estimating

Parametric cost estimating is the use of

historical cost data and statistical techniques
(e.g., linear regression) to predict future costs.
Parametric models are used in the early design
stages to get an idea of how much the product
(or project) will cost, on the basis of a few
physical attributes (such as weight, volume,
and power).

Engineering Economy
The power-sizing technique (or exponential model)
is frequently used for developing capital
investment estimates for industrial plants and
equipment.

(both in $ as of the point in time

for which the estimate is desired)

(both in the same physical units)

Enineering Economy
Example
Acme Logistics provides “Less than truck load” (LTL)
services throughout the U.S. They have several hubs
where they use cross-docking to move goods from
one trailer to another. Acme built its last hub 10
years ago, and it had 36 dock doors. The cost index
at that time was 140, and the total cost was $6
million. Acme plans a new hub that will have 48
dock doors. The cost index now is 195, and Acme will
use a capacity factor of 0.82. What is the estimated
cost of the new hub?

Engineering Economy
Learning Curves

A learning curve reflects increased efficiency

and performance with repetitive production of
a good or service. The concept is that some
input resources decrease, on a per-output-unit
basis, as the number of units produced
increases.

Engineering Economy
Most learning curves assume a constant
percentage reduction occurs as the
number of units produced is doubled.
Learning curve example
Assume the first unit of production required 3 hours
time for assembly. The learning rate is 75%. Find
(a) the time to assemble the 8th unit, and
(b) the time needed to assemble the first 6 units.

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Cost Estimating Relationship
A cost estimating relationship (CER)
describes the cost of a project as a function
of design variables. There are four basic
steps in developing a CER.
Problem definition
Data collection and normalization
CER equation development
Model validation and documentation

Engineering Economy
Capital
The term «capital» refers to wealth in the form
of money or property that can be produced to
produce more wealth.
Majority of engineering economy studies involve
commitment of capital for extended periods of
time  effect of time must be considered!
A dollar today has more value than a dollar one or
more years from now because it can earn interest
(profit)

Engineering Economy
Capital
Capital in an organization can be:
Equity capital, owned by individuals who have
invested their money in a business with the hope of
profit.
Debt capital, obtained from lenders (through the
sale of bonds) for investment: lenders receive
interest.
Why profit and interest are important for
engineering economy?

Engineering Economy
Simple Interest
Interest earned is linearly proportional to the
initial amount of the loan, the interest rate,
and the number of interest periods.
I= (P)*(N)*(i)
Not frequently used in commercial practice.

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Compound Interest

Compound interest reflects both the remaining principal and any

accumulated interest. For $1,000 at 10%…

(1) (2)=(1)x10% (3)=(1)+(2)

Amount owed at Interest amount for Amount owed at
Period beginning of period period end of period
1 $1,000 $100 $1,100

2 $1,100 $110 $1,210

3 $1,210 $121 $1,331

Compound interest is commonly used in personal and

professional financial transactions.
Engineering Economy
Concept of Equivalence
In order to compare alternatives we need to
reduce them to an equivalent basis dependent
on:
The interest rate
The amounts of money involved
The timing of the monetary receipts/expences
The manner in which the interest rate/profit paid
and the initial capital recovered.

Engineering Economy
Notation
i: effective interest rate per interest period
N: number of compounding periods
P: present sum of money (the equivalent value
of one or more cash flows at a reference point
in time called the present)
F: future sum of money (the equivalent value
of one or more cash flows at a reference point
in time called the future)
A: end-of-period cash flows in a uniform series

Engineering Economy
A cash flow diagram is an indispensable tool
for clarifying and visualizing a series of cash
flows.

Engineering Economy
Cash flow tables are essential to modeling
engineering economy problems in a
spreadsheet

Engineering Economy
We can apply compound interest formulas
to “move” cash flows along the cash flow
diagram.
Using the standard notation, we find that a
present amount, P, can grow into a future
amount, F, in N time periods at interest rate
i according to the formula below.

In a similar way we can find P given F by

Engineering Economy
It is common to use standard notation
for interest factors.

This is also known as the single payment

compound amount factor. The term on the
right is read “F given P at i% interest per
period for N interest periods.”

is called the single payment present worth

factor.
Engineering Economy
 We can use these to find economically
equivalent values at different points in time.
$2,500 at time zero is equivalent to how much after six
years if the interest rate is 8% per year?

$3,000 at the end of year seven is equivalent to how

much today (time zero) if the interest rate is 6% per
year?

Engineering Economy
Example

Betty will need $12,000 in five years to pay

for a major overhaul on her tractor engine.
She has found an investment that will
provide a 5% return on her invested funds.
How much does Betty need to invest today
so she will have her overhaul funds in five
years?

Engineering Economy
There are interest factors for a series of
end-of-period cash flows.

How much will you have in 40 years if you

save $3,000 each year and your account
earns 8% interest each year?

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Finding the present amount from a series
of end-of-period cash flows.

How much capital is needed today to provide

an annual amount of $50,000 each year for 20
years, at 9% interest each year?

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 Finding A when given F.

How much would you need to set aside each

year for 25 years, at 10% interest, to have
accumulated $1,000,000 at the end of the 25
years?

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 Finding A when given P.

If you had $500,000 today in an account

earning 10% each year, how much could you
withdraw each year for 25 years?

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Example

Acme Steamer purchased a new pump for $75,000.

They borrowed the money for the pump from their
bank at an interest rate of 0.5% per month and will
make a total of 24 equal, monthly payments. How
much will Acme’s monthly payments be?

Engineering Economy
It can be challenging to solve for N or i.

We may know P, A, and i and want to find N.

We may know P, A, and N and want to find i.
These problems present special challenges that
are best handled on a spreadsheet.

Engineering Economy
 Finding N
Acme borrowed $100,000 from a local bank, which
charges them an interest rate of 7% per year. If Acme
pays the bank $8,000 per year, how many years will it
take to pay off the loan?

So,

This can be solved by using the interest tables and

interpolation, but we generally resort to a computer
solution.

Engineering Economy
 Finding i
Jill invested $1,000 each year for five years in a local
company and sold her interest after five years for
$8,000. What annual rate of return did Jill earn?

So,

Again, this can be solved using the interest tables

and interpolation, but we generally resort to a
computer solution.
Engineering Economy
There are specific spreadsheet functions
to find N and i.
The Excel function used to solve for N is
NPER(rate, pmt, pv), which will compute the
number of payments of magnitude pmt required to
pay off a present amount (pv) at a fixed interest
rate (rate).
One Excel function used to solve for i is
RATE(nper, pmt, pv, fv), which returns a fixed
interest rate for an annuity of pmt that lasts for nper
periods to either its present value (pv) or future value
(fv).
Engineering Economy
Engineering Economy Functions in Excel
NOMINAL(effect_rate, npery) - computes nominal rate
EFFECT(nominal_rate, npery) - computes effective rate
RATE(nper,pmt,pv,fv,type,guess) - computes interest rate of an annuity (periodic amounts are the 'pmt'
values)
PV(rate,nper,pmt,fv,type) - computes present worth value of periodic amounts; does not include any cash
flow in year 0
FV(rate,nper,pmt,pv,type) - computes the future worth value of an periodic payments
NPV(rate,value1,value2, ...) - computes the PW of some non-uniform stream of cash flows; does not
include cash flow in year 0
NPER(rate, pmt, pv, fv, type) - computes number of payment periods for a stated PV to equal a stated FV
PMT(rate,nper,pv,fv,type) - computes periodic payment for an annuity
IPMT(rate,per,nper,pv,fv,type) - computes interest portion of a specific payment for some period of time
PPMT(rate,per,nper,pv,fv,type) - computes principal portion of a payment for some period
CUMIPMT(rate,nper,pv,start_period,end_period,type) - computes cumulative interest paid on a loan over
some interval
CUMPRINCE(rate,nper,pv,start_period,end_period,type) - computes cumulative principal paid on a loan
over some interval
IRR(range,guess) – returns the IRR for cash flows in the specified range
VDB(B, SVn, N, start, end, percent, no_switch) – returns dk for the declining balance depreciation method

Engineering Economy
We need to be able to handle cash
flows that do not occur until some
time in the future.
Deferred annuities are uniform series that
do not begin until some time in the future.
If the annuity is deferred J periods then the
first payment (cash flow) begins at the end
of period J+1.

Engineering Economy
Finding the value at time 0 of a deferred
annuity is a two-step process.
1. Use (P/A, i%, N-J) find the value of the
deferred annuity at the end of period J
(where there are N-J cash flows in the
annuity).
2. Use (P/F, i%, J) to find the value of the
deferred annuity at time zero.

Engineering Economy
Example
Irene just purchased a new sports car and wants to
also set aside cash for future maintenance
expenses. The car has a bumper-to-bumper
warranty for the first five years. Irene estimates that
she will need approximately $2,000 per year in
maintenance expenses for years 6-10, at which time
she will sell the vehicle. How much money should
Irene deposit into an account today, at 8% per year,
so that she will have sufficient funds in that account
to cover her projected maintenance expenses?

Engineering Economy
 Sometimes cash flows change by a
constant amount each period.
We can model these situations as a uniform gradient
of cash flows. The table below shows such a
gradient.
End of Period Cash Flows
1 0
2 G
3 2G
: :
N (N-1)G

Engineering Economy
It is easy to find the present
value of a uniform gradient
series.
Similar to the other types of cash flows, there is a
formula (albeit quite complicated) we can use to find
the present value, and a set of factors developed for
interest tables.

Engineering Economy
 We can also find A or F
equivalent to a uniform gradient
series.

Engineering Economy
The annual equivalent of End of Year Cash Flows ($)
this series of cash flows can 1 2,000
be found by considering an
2 3,000
annuity portion of the cash
flows and a gradient 3 4,000
portion. 4 5,000
End of Year Annuity ($) Gradient ($)
1 2,000 0
2 2,000 1,000
3 2,000 2,000
4 2,000 3,000

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 Sometimes cash flows change by a
constant rate, ,each period--this is a
geometric gradient series.

This table presents a End of Year Cash Flows ($)

geometric gradient series. It
1 1,000
begins at the end of year 1
and has a rate of growth, , 2 1,200
of 20%. 3 1,440
4 1,728

Engineering Economy
We can find the present value of a
geometric series by using the
appropriate formula below.

Where is the initial cash flow in the series.

Engineering Economy
Example

Acme Miracle projects good things for their

new weight loss pill, LoseIt. Revenues this
year are expected to be $1.1 million, and Acme
believes they will increase 15% per year for
the next 5 years. What are the present value
and equivalent annual amount for the
anticipated revenues? Acme uses an interest
rate of 20%.

Engineering Economy
When interest rates vary with time
different procedures are necessary.
Interest rates often change with time (e.g.,
a variable rate mortgage).
We often must resort to moving cash flows
one period at a time, reflecting the interest
rate for that single period.

Engineering Economy
The present equivalent of a cash flow occurring at
the end of period N can be computed with the
equation below, where ik is the interest rate for the
kth period.

If F4 = $2,500 and i1=8%, i2=10%, and i3=11%, then

Engineering Economy
Nominal and effective interest
rates.
More often than not, the time between
successive compounding, or the interest period, is
less than one year (e.g., daily, monthly, quarterly).
The annual rate is known as a nominal rate.
A nominal rate of 12%, compounded monthly,
means an interest of 1% (12%/12) would accrue
each month, and the annual rate would be
effectively somewhat greater than 12%.
The more frequent the compounding the greater
the effective interest.

Engineering Economy
 The effect of more frequent
compounding can be easily
determined.
Let r be the nominal, annual interest rate and M the
number of compounding periods per year. We can
find, i, the effective interest by using the formula
below.

Engineering Economy
Finding effective interest rates.

For an 18% nominal rate, compounded quarterly, the

effective interest is.

For a 7% nominal rate, compounded monthly, the

effective interest is.

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Interest can be compounded continuously

Interest is typically compounded at the end

of discrete periods.
In most companies cash is always flowing,
and should be immediately put to use.
We can allow compounding to occur
continuously throughout the period.
The effect of this compared to discrete
compounding is small in most cases.

Engineering Economy
We can use the effective interest
formula to derive the interest
factors.

As the number of compounding periods gets

larger (M gets larger), we find that

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Continuous compounding
interest factors.

The other factors can be found from these.

Engineering Economy