Engineering Economics

Lectures 2 Topics:
• Project Life Cycle Concepts and
Cost Estimating
• Learning Curve
• Breakeven Analysis

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 Projects Life Cycle
• Similar to human projects go through life cycle.
– A process through which a project is implemented
from cradle to grave.
• Project life cycle can be decomposed into
several stages (phases).
• Each phase of the life cycle has duration.
– The project reach a peak point and then terminate.

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•The following figure illustrate the typical phases that
a product, goods, or services progress through over
its life cycle (Text Book).

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Projects Life Cycle Costing:
• Life-cycle costing is the concept of designing
products, goods and services with a full
recognition of the associated costs over the
various phases of their life cycles.
• Life cycle costing key concepts:
– The later a design change is made, the higher the
cost.
– Decisions made early in the life cycle tend to ‘lock
in’ costs that will be incurred later.

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• Costs are committed early in the project life cycle:
- In the following figure, nearly 70% – 90% of all costs are set (decided) during
the design phase while only 10% - 30% of cumulative life cycle cost have been
spent (Text Book).

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• Downstream (late in the life cycle) project changes are more costly and upstream
(early in the life cycle) are easier and less costly.

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 Project Cost Estimating

Cost Estimating is the process of

collecting, analyzing, and summarizing
data in order to prepare and educated
projection of the anticipated cost of a
project.

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• Difficulties in Estimation:
Cost estimating is a difficult task since it is not
easy to foresee future economic consequences.
The following are some aspects that make cost
estimating a challenging task:
– One-of-a-kind estimates:
• First time projects are difficult to estimate their
costs. Consider difficulties faced by space
agencies while developing cost estimates for the
first time missions.
• Normally, new products cost estimates are
developed using data from similar products with
known costs (estimate by analogy).

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• Difficulties in Estimation:
– Time and effort available:
• Cost estimating is constrained by time and the
availability of person-power.
• To develop detailed estimates resources must be
planned.
– Estimator expertise:
• The more experienced and knowledgeable the
estimator is, the more accurate the estimate will
be.

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 Types of Cost Estimate
• Three general types of estimates can be
defined:
1) Rough estimates (Order-of-magnitude
estimates):
– An estimate made without detailed engineering
data.
– Used for project’s initial feasibility, planning and
evaluation phases.
– Quick and easy estimate.
– Accuracy: -30% to +60%.

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2) Budget estimates:
– Used for budgeting purpose at the conceptual
or preliminary design stages of a project.
– Budget refers to owner budget and not to the
budget as a project control document.
– These estimates are more detailed and require
more resources than the rough estimates.
– Prepared using flow sheets, layouts and
equipment details.
– Accuracy: -15% to +20%.

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3) Detailed estimates:
– Used during project’s detailed design and
contract bidding phase.
– Prepared using detailed quantitative models,
specification sheets and vendor quotes.
– Require the most time and resources to develop
and thus more accurate than rough or budget
estimate.
– Accuracy: -3% to +5%.

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 Cost Estimating Models
• Cost estimating models can be used at
rough, budget and detailed levels.
• Rough estimates are used with rough data
and detailed estimate are used with
detailed data.
• Cost estimating models:
Per-Unit, Segmenting, Cost Indexes, and
Power-Sizing.

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1) Per-Unit Model:
• This model uses per unit factor, such as cost per
square foot, to develop the estimate desired.
• Simplistic and used to develop order of
magnitude estimates.
• For example if you are interested in building
2000 square foot floor plan house. A contractor
may quote a $65 per square foot for your house.
The house total cost = 2000 x 65 = $130,000.

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2) Segmental Model:
• An estimate is decomposed into its individual
components. Cost estimates are made at those
lower levels, and then the estimate is aggregated
(added) back together.
• Scheme developed from decomposing cost
elements is known as work breakdown structure.

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 Define WBS for Products (House)
1.0
House

1.1 1.2 1.3 1.4

Concrete Roofing Electrical Interior

1.1.1 Foundations 1.2.1 Felt 1.3.1 House Wiring 1.4.1Wall

1.1.2 Side Walks 1.2.2 Shingles 1.3.2 Garage Wiring 1.4.2 Cabinets
1.1.3 Patio 1.2.3 Roof Caps 1.3.3 Outlet/Switches 1.4.3 Trim
1.1.4 Landscaping 1.3.4 Service Cable 1.4.4 Carpet
1.6
1.5 1.3.5 Fixtures 1.4.5 Exterior Brick
Framing Window / Doors
1.7

1.6.1 Windows
Plumbing
1.5.1 Exterior Walls
1.5.2 Interior Walls
1.6.2 Exterior Doors
1.7.1 Waste Lines
1.5.3 Trusses 1.6.3 Interior Doors 1.7.2 Water lines

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Example:
You are the production engineer for Clean Lawn Corp. The
company is planning to develop a new lawn mower called the
Grass Eater. The accounting department contacted you to
estimate the cost of the material that will makeup the new
mower. The material cost will be used, along with estimates
for labour and overhead to evaluate the potential of this new
model.
Solution:
You Use a segmenting approach to develop estimates. To
develop the estimate, decompose the design specifications
into its components, estimate the material costs for each
components, and then add these costs up to obtain the
material overall estimate.
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After studying the design and the specification, you divide the
mower into the following major subsystem: chassis, drive
train, controls, and cutting and collecting system.

The total material cost estimate of $163.45 is estimated by

adding the estimates of the four major components.
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3) Cost Indexes:
• Cost indexes are historical records of engineering
(and other) elements.
• Cost indexes reflect relative price change in either
individual cost items (labour, material, utilities) or
group of costs (consumer prices, producer prices)
• Indexes can be used to update historical costs
with the basic ratio relationship given in the
following equation:
Cost at time A Index valu e at time A

Cost at time B Index valu e at time B

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Example:
An engineer is interested in estimating the annual labour and
material costs for a new production facility. She was able to
obtain the following cost data:
• Labour costs:
– Labour cost index was at 124 ten years ago and is 188
today.
– Annual labour costs for a similar facility were $575,500 ten
years ago.
• Materials
– Material cost index value was at 544 three years ago and
is 715 today.
– Annual material costs for a similar facility were $2,455,000
three years ago.
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Solution:
Labour:
Annual cost today Index valu e today

Annual cost 10 years ago Index valu e 10 years ago
Annual cost today = 188/124 x $575,500 = $871,800

Material:
Annual cost today Index valu e today

Annual cost 3 years ago Index valu e 3 years ago

Annual cost today = 715/544 x $2,455,000 = $3,227,000

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- Location Indexes:
• Some factors affect cost in different locations:
1. Transport cost
2. Labour supply and local productivity
3. Codes and local inspection
• Published indices of local construction costs in
major cities can be used to account for these
elements.
Cost at location A Index for location A

Cost at location B Index for location B

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4) Power-Sizing Model:
• Used to estimate the cost of industrial plants and
equipments.
• The model scales up or scales down known costs.
• The power-sizing model use the exponent (x), called the
power-sizing exponent to represent economics of scale in
size or capacity:
x
Cost of equipment A  Size (capicity) of equipment A 
  
Cost of equipment B  Size (capicity) of B 

Where cost of A and B are the same point in time (same

dollar basis)

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• The power sizing exponent values for plants and
equipments of many types are found in several sources
such as reference books and technical journals.
• The following table gives this exponent for some
industrial facilities and equipments (Text Book).

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Example – Order of Magnitude:
A 300-mlpd (million liters per day) water treatment
plant is proposed to be built in 2020 for Sharjah,
UAE. A 200-mlpd plant using the same treatment
process was built in 2013 in Jeddah, Saudia Arabia
for $60,000,000. Make an order of magnitude
estimate based on the following additional
information and assumptions.
1. Poor site condition in Jeddah required an additional
$4,000,000 for foundations, which is not anticipated for
Sharjah.
2. Assume the size exponent m = 0.67.
3. Assume inflation will persist at an average 0.5 % per
month.
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 4. Assume the location index for Jeddah is 1.17 and is
1.24 for Sharjah.
5. A new high-pressure filter process will be added at
Sharjah at an additional cost of $5,000,000.
6. The contingency cost due to labour availability will be
reduced by the amount of 1% of total construction
cost because of the availability skilled labour in
Sharjah.
On the basis of the above conditions, estimate the
cost for the new project.

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 Solution:
1. Typical cost excluding the additional cost due to poor
site conditions in Jeddah
$60 million - $4 million = $ 56 million
2. Adjustment for capacity based on the exponential law
yields
($56)(300/200)0.67 = (56) (1.5)0.67 = $73.480 million
3. Adjustment for inflation leads to the cost in 2018 dollars
as: ($73.480)(1.005)84 = $111.717 million
4. Adjustment for location index gives
($111.717)(1.24/1.17) = $118.401 million
5. Adjustment for the additional filter at Sharjah plant gives
$118.401 million + $5 million = $123.401 million

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6. Reduction in contingency cost yields:
($123.401)(1-0.01) = $122.167 million
The order of magnitude estimate for the new project is
$122.167 million.

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• Classification of the different cost
concepts:
– Fixed costs are constant regardless of the level of output
or productivity. In contrast variable costs depend on the
level of output or activity.
– Marginal cost is the cost for one more unit, while average
cost is the total cost divided by the number of units.
– Sunk cost is money already spent as a result of past
decision.
• Sunk cost should be disregarded in our engineering
economic analysis because current decisions cannot
change the past.

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• Classification of the different cost
concepts:
– Opportunity cost is associated with using a
resource in one activity instead of another.
• Every time we use a business resource (equipment,
dollar, manpower, etc.) in one activity we give up the
opportunity to use the same resource in that time in
some other activity.
– Incremental costs refer to the principle that when
one makes a choice among a set of competing
alternatives, the emphasis should be on the
differences between those alternatives.

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 Learning Curve
– As the number of repetition increases,
performance becomes faster
– Learning Curve Rate: A percentage or rate at
which output is increased due to repetition:
– Estimating time in repetitive tasks:
TN=TInitial x Nb
• TN = time required for Nth unit of production
• TInitial = time required for the first unit of production
• N = number of completed units
• b = learning curve exponent = log (learning curve as
decimal)/log 2.0

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Example:
Time to produce first unit: 32 minutes
Learning curve rate: 80%
Time to produce 100th unit: ?
Solution:
T100=T1 x Nlog 0.80 / log 2.0
= 32.0 x 100-0.3219
= 7.27 minutes

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Example:
Estimate the overall labour cost for a task with a
learning curve rate of 85%. The task reaches a
steady state after 16 units of 5 minutes per unit.
The task consists of 20 units and require 2
workers. The worker rate = $22/hour
Solution:
T16=T1 x Nlog 0.85 / log 2.0
5.0 = T1 x 16-0.2345
T1 = 9.6 minutes

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Calculate the time requirements for each unit (Unit 1
to 20) using: TN = 9.6 x N -0.2345

The total time for the task is 119.8 minutes (2 hours)

Total labour cost = 2 hours x $22/hour x 2 workers
= $88
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 Breakeven Analysis
• Breakeven analysis attempts to reflect the
cost and revenue performances.
• One objective: Find the breakeven quantity
for a decision variable to achieve specific
profit.
• This quantity is the breakeven point, QBE.
• To do that: Analyze the revenue and cost
performance to estimate QBE.
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 Cost Models – Fixed Costs
• Fixed Costs – Cost that do not vary with
production or activity levels:
– Costs of buildings;
– Insurance;
– Fixed Overhead;
– Equipment capital recovery….etc.
• If no level of activity, fixed costs continue:
– Shut down the activity to eliminate fixed costs;

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 Cost Models-Variable Costs
• Variable Costs change with the level of
activity:
– More activity – greater variable costs;
– Less activity – lower variable costs;
• Variable costs are impacted by efficiency
of operation, improved designs, quality,
safety, and higher sales volume.

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 Cost Models-Variable Costs
• Costs that vary with the level of activity:
– Direct Labor – wages;
– Materials;
– Marketing;
– Advertising;
– Warranty;
– Etc.

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 Breakeven Analysis
• Revenue is total amount of money
collected from selling products or services.
• At a specific quantity Q, the revenue and
the total cost relations intersect:
– This is the breakeven point QBE

• Revenue and cost relations can be linear

or nonlinear.
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 Total Costs
• Total Cost = Fixed Costs + Variable Costs;
TC = FC + VC
where VC can be linear or nonlinear.

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 Linear Breakeven

BE point
changes
when the
VC is
lowered

Figure 16-2 Effect on the breakeven point when the variable cost per unit is reduced.

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 Linear Breakeven
• Profit Relationships:
Profit = Revenue – Total Cost
P = R – TC
P = R –{FC + VC}
• If revenue and total cost are linear, the QBE can
be derived by equating revenues to total costs:
R = TC

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 Linear Breakeven
R = TC
rQBE = FC + VC = FC + vQBE
where r is revenue per unit and v is variable
cost per unit
QBE = FC / (r – v)

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Example:
A Corporation assembles up to 30 trailers per month for 18 wheel
trucks. Production has dropped to 25 units per month over the last 5
months due to a worldwide economic slow down in transportation
services. The following information is available.
Fixed costs FC = $750,000 per month
Variable cost per unit v = $35,000
Revenue per unit r = $75,000
(a) How does the reduced production level of 25 units per month
compare with the current breakeven point?
(b) What is the current profit level per month for the facility?
(c) What is the difference between the revenue and variable cost per
trailer that is necessary to break even at a monthly production level of
15 units, if fixed costs remain constant?

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Solution:
(a) Use the equation to determine the breakeven number of units. All
dollar amounts are in $1000 units.
QBE = FC / (r – v) = 750 / (75 – 35) = 18.75 units per month
The following figure is a plot of R and TC lines. The breakeven
value is 18.75, or 19 in integer trailer units. The reduced production
level of 25 units is above the breakeven value.

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Solution:
(b) To estimate profit in $1000 at Q = 25 units per month:
Profit = R - TC = rQ - (FC + vQ)
= (r - v)Q - FC
= (75 - 35)25 - 750
= $250
There is a profit of $250,000 per month currently.
(c) To determine the required difference r - v, use the equation with
profit = 0, Q = 15, and FC = $750,000. In $1000 units,
0 = (r - v)(15) - 750
r - v = 750/15 = $50 per unit
The spread between r and v must be $50,000. If v stays at $35,000,
the revenue per trailer must increase from $75,000 to $85,000 just
to break even at a production level of Q =15 per month.

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