LESSON 4: COST ESTIMATING FUNDAMENTALS

Lesson Rationale:
The lesson contains the fundamentals in cost estimating, elements of cost, types of cost, and cost properties by means of
costs reduced, thus maximizing profit. In these instances, an engineer would be more valuable to cost estimating management.

Lesson Outcomes:
At the end of the lesson, you are expected to:
1. Familiarize the basic definition of depreciation and depletion;
2. Understand the types of depreciation and methods of theoretical depletion charge;
3. Apply different formulas of depreciation and depletion;
4. Analyze the samples problems; and
5. Evaluate yourself in the assessment activity.

Lesson Contents:
Topic 1: Capitalized and Annual Cost
Topic 2: Classification of Cost
Topic 3: Elements of Cost

4.1 Capitalized Cost

As a natural extension and application of perpetuity, we have capitalized cost. The capitalized cost of any structure or property
(equipment, machinery, building, etc.) is the sum of its first cost and the present worth of all costs for replacement, operation, and
maintenance for a long time or forever, that is,

𝑪𝒂𝒑𝒊𝒕𝒂𝒍𝒊𝒛𝒆𝒅 𝑪𝒐𝒔𝒕 = 𝑭𝒊𝒓𝒔𝒕 𝑪𝒐𝒔𝒕 + 𝑴𝒂𝒊𝒏𝒕𝒆𝒏𝒂𝒏𝒄𝒆 𝑪𝒐𝒔𝒕

 Case I: Only maintenance

𝑨
𝑪𝑪 = 𝑪𝑶 + 𝑷 𝑷=
𝒊
 Case II: Only replacement
𝑷
𝑪𝑪 = 𝑪𝑶 +
(𝟏 + 𝒊)𝒏 − 𝟏

 Case III: Maintenance and replacement every period

𝑨 𝑷
𝑪𝑪 = 𝑪𝑶 + +
𝒊 (𝟏 + 𝒊)𝒏 − 𝟏

where; CC= capitalized cost or total capital needed;

Co= first cost or initial capital invested
A= annual operating cost or annual expenses;
P= present worth of all the annual operating cost
𝑖=standard interest rate
Sample Problems:
Example 1: A barangay road was constructed for ₱300,000. Determine the capitalized cost of the road if the annual
maintenance cost is ₱5,000. Assume money is worth 5% per annum.

Use Case I, n=∞

Example 2: A dam has a first cost of ₱5,000,000. It has an annual maintenance cost of ₱25,000 and minor reconstruction
costs to accumulate of an ordinary annuity of ₱100,000 every 5 years. At an interest of 8% per year, what is the capitalized cost of the
dam?

Example 3: At 6%, find the capitalized cost of a bridge whose cost is ₱250M and whose life is 20 years, if the bridge must be
partially rebuilt at a cost of ₱100M at the end of each 20 years.

Use Case II:

Solution: 𝐶𝑂 = ₱250𝑀 𝑃 = ₱100M 𝑛 = 20 𝑦𝑒𝑎𝑟𝑠 𝑖 = 6%

𝑃 ₱100M
𝐶𝐶 = 𝐶𝑂 + = ₱250𝑀 + = ₱𝟐𝟗𝟓, 𝟑𝟎𝟕, 𝟔𝟎𝟎
(1 + 𝑖)𝑛 − 1 (1 + 0.06)20 − 1

Example 4: A new broiler was installed by a textile plant at a total cost of ₱300,000 and is projected to have a useful life of 15
years. At the end of its useful life, it is estimated to have a total all-annual operating cost of ₱100,000 with an annual maintenance cost
of ₱5,000. Determine its capitalized cost if interest is 18% compounded annually.

Apply Case III:

𝐴 𝑃 ₱5,000 ₱100,000
𝐶𝐶 = 𝐶𝑂 + + 𝑛 = ₱300,000 + + = ₱𝟑𝟑𝟔, 𝟖𝟗𝟎. 𝟒𝟑
𝑖 (1 + 𝑖) − 1 0.18 (1 + 0.18)15 − 1
4.2 Annual Cost

The annual cost of any structure or property is the sum of the annual depreciation cost, the interest of the first cost, and the
annual operating and maintenance costs.

𝑨𝒏𝒏𝒖𝒂𝒍 𝑪𝒐𝒔𝒕 = 𝑨𝒏𝒏𝒖𝒂𝒍 𝒅𝒆𝒑𝒓𝒆𝒄𝒊𝒂𝒕𝒊𝒐𝒏 𝒄𝒉𝒂𝒓𝒈𝒆 + 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒐𝒇 𝒕𝒉𝒆 𝒇𝒊𝒓𝒔𝒕 𝒄𝒐𝒔𝒕

+ 𝒂𝒏𝒏𝒖𝒂𝒍 𝒐𝒑𝒆𝒓𝒂𝒕𝒊𝒏𝒈 𝒂𝒏𝒅 𝒎𝒂𝒊𝒏𝒕𝒆𝒏𝒂𝒏𝒄𝒆 𝒄𝒐𝒔𝒕𝒔

𝑨𝑪 = 𝒅 + 𝑪𝑶 𝒊 + 𝑶. 𝑴

where; AC= annual cost or total annual expenses

d= annual depreciation cost
Co = first cost or initial or initial capital invested
𝑖= annual interest of capital invested
O.M= operating maintenance cost

Note: If an interest rate is given, and the method of computing depreciation is not specified, use the sinking fund
method. If not, then use the straight-line method.

Sample Problems:
Example 1: A company bought a piece of equipment costing ₱30,000 with a guaranteed economic life of 8 years and a resale
value of ₱5,000. If the money is worth 10%, what is the annual cost of the equipment? Use the straight-line method for depreciation
analysis.

Example 2: A machine has an initial cost of ₱40,000 and an annual maintenance cost of ₱5,000. Its useful life is 10 years.
The sinking fund annual benefit from purchasing the machine is ₱18,000. The effective interest rate is 10%, what is the annual cost of
the machine?
Practice Problem!
1. A granite quarry purchased for P1,600,000 is expected to be exhausted at the end of 4 years. If the resale value of the land is
P100,000, what annual income is required to yield an investment rate of 12%? Use a sinking fund rate of 3%.
Ans. ₱550,540.67

2. A man planned of building a house. The cost of construction is P500,000 while the annual maintenance cost is estimated at
P10,000. If the interest rate is 6%, what is the capitalized cost of the house? Ans. ₱666,666,67

3. A tractor manufacturer signs a long-term contract with a farm consortium to provide a new tractor every 5 years. If the cost of
each tractor is ₱24,000 in an ordinary annuity payment, determine the capitalized cost of the contract. Assume an interest rate
of 6% over the life of the contract. Ans. ₱94,958

4. A pipe line was built using a pipe that costs ₱100,000 with a guaranteed useful life of 20 years. If money is worth 6%
compounded annually, what is the equivalent annual cost of the pipeline? Ans. ₱8,718.45

5. The construction of a volleyball court is expected to cost ₱105,200 and have annual maintenance costs of ₱3,200. At an
effective annual interest rate of 5%, what is the project’s capitalized cost? Ans. ₱169,200

4.3 Categories of Cost

Many classifications of cost arise in economic studies of a new or existing enterprise whenever any change in operations or
policy is made. While an engineer may be cognizant of the various types of costs, it appears that classifying the same and giving the
applications of each will make them clearer.
The following classification of the cost will be defined and explained. Cost classification is an extensive motive. We can divide
the cost classification into several categories. Here are including the main categories.
Classification of Cost is an extensive motive. We can divide the cost classification into several categories. Here are including
the main categories.
 Classification of cost according to the element
 Cost classification according to function
 Depending on behavior
 According to relevancy
 According to management

4.3.1 Classification of Cost according to the Element

According to the element, cost can be divided into two main categories. It is also known as the classification of cost
by nature.

A. Direct cost
It is such a cost that is able to mark directly any particular cost such as raw materials, labor included operating
expenses and some other costs are belongs to the direct cost. These costs are bound in a unit. For example, we can say a
total cost of an advertisement for several products. The direct cost has some subcategories.

a. Direct element: Direct element refers to that material that is related to the entire finished product. This material is
a part to complete any product. It can have imposed conveniently on a particular product. The purchased and upcoming
requisite products are included in the direct element. As like, all kinds of initial packing material.
b. Direct labor: Direct labor means the paid salary to the employee who is directly engaged in manufacturing,
handling, and processing a product. Actually, they are responsible for the observation and maintenance of the product also.
c. Direct expense: Which cost is directly related to any particular expense is called direct expense. If a company
needs to buy some specific product, equipment or tools are the examples of direct expense.
B. Indirect cost
Indirect cost means the opposite side of direct cost. Which cost is related to a unit or department and can’t trace for
any specific product is called indirect cost. The indirect cost has also some subcategories.
a. Indirect element: Some example of indirect materials is cleaning chemicals, small tools, glue, and maintenance
work. Fuel etc. These element costs are incurred as a unit.
b. Indirect labor: Indirect labor is covering the supervisor’s and the inspector’s salary. The worker of cleaners’ and
storekeeper’s wages is also included in the indirect labor.
c. Indirect expenses: Indirect expenses are house rent, hospital service, lighting, insurance, and welfare trust.

Types of Indirect Overheads:

 Factory overheads:
It is related to all kinds of indirect costs like manufacturing products and time keeper’s salaries.
 Selling and distribution overhead:
This overhead is included with advertising expenses and packing materials costs such as free
advertising and marketing on the field.
 Administration and office overhead:
Administrative expenses are an expense of office works related expenses such as office lighting,
rent welfare trust are included here.

4.3.2 Cost Classification according to Function

Cost is classified by the following categories. The main three categories of functional costs are given below;
a. Prime cost: Prime cost is the adjustment of the direct material, direct labor, and direct costs. It is actually the
result of these three elements.
b. Product cost: It means the factory cost with administrative and office overheads
c. Factory cost: Factory cost is also known as work cost. It is combined with work cost and work expenses

4.3.3 Depending on Behavior

By behavior or variability cost is classified as Variable cost, Fixed cost, and Mixed cost which is explained below.
a. Variable cost: Variable cost is such a cost whose proportion is changing with the amount of production. Such as
direct material and changeable costs. This cost varies with output or any change in the activities of an enterprise. For
example, the cost of materials used depends on the output. In general, all costs for direct materials, direct labor, and other
items which can be directly allocated to each unit produce are classified as variable cost.
b. Fixed cost: This cost won’t change with the proportion of production. It is the maximum time fixed. But it is notable
that this cost may be changed after a long time. For example, office rent, insurance, and hospital cost. This cost is those
whichremainsn relatively constant regardless of any change made in operations or policy. Thus, the rental of a property may
remain unchanged even if the output of a factory changes a great deal. The depreciation of piece of equipment remains
constant regardless of its output. Fixed costs consist of such items as: rentals on building, depreciation maintenance, taxes,
insurance, interest on borrowed capital, and some administrative expenses.
c. Mixed cost: Mixed cost can change overall but not with the proportion of production. More changeable cost
discounted under a Mixed cost. An example of a mixed cost is electricity expenses.

4.3.4 According to Relevancy

Classification of cost according to Relevance is base cost is mainly divided into five categories which are given
below;
a. Relevant cost: Which cost can be by making a new decision is called relevant cost. Occasionally there may have
many relevant costs. This cost is not fixed from before.
 b. Opportunity cost: Opportunity cost is the system of getting some extra advantages from the existing things of a
factory like land, money and time, etc. Someone can rent his office for another purpose of advantages. Moreover, they can
rent their other things also. It is actually an extra benefit for a company.
c. Standard cost: Standard cost is fixed from previous experience. It was fixed according to the specific budget, and
the volume of the industry. The actual cost is also included with this cost.
d. Controllable cost: Which cost can be controlled by management is called controllable cost. The manager can
control some costs.
e. Sunk cost: It is known as a historical cost. Sunk cost effect is the most important for a company. It is such a cost
that is already lost and can’t be undone anymore. If a company is paid its monthly rent then we can say this rent cost is sunk
cost.

4.3.5 Classification of Cost according to Management

These costs are mainly divided into two categories; Manufacturing cost and Non-manufacturing cost given are given
below;
a. Manufacturing cost: Manufacturing cost refers to the total cost of a product from the raw materials to finish the
product. It is mainly the combination of direct material cost, labor cost, and manufacturing overheads.
b. Non-manufacturing cost: In order, the rules of GAAP Non-manufacturing cost are not actual product cost. It is a
part of the company’s income statement.

4.4 What are the three elements of cost?

From the standpoint of the economist, the three elements of production are land, labor, and capital. However, from the
viewpoint of management, it is known that every finished product has an actual cost consisting of the following:
1. The cost of materials used in production.
2. The cost of direct labor employment in production, and
3. Other expenses not included in materials and direct labor are grouped under the name overhead expenses or burden.

A. Materials used in manufacturing are classified as either direct materials or indirect materials.
1. Direct materials- are those which are used in the finished product itself, while;
2. Indirect materials- those materials used in production but which do not go into the finished product.
For instance, the quantity of water that directly goes into the manufacture of ice is direct material but the water used
in cooling the ice factory is an indirect material.

B. Labor
Like materials, labor is also classified into direct labor and indirect labor.
1. Direct Labor- is the actual work applied directly to the manufacture of the product.
2. Indirect Labor- is that work necessary for the operation of the factory, but which cannot be identified with one
particular process product manufactured.
The labor performed by janitors, security guards, and timekeepers are included under indirect labor.

C. Overhead Expenses or Burden

This consists of those expenses which cannot be allocated to direct materials or direct labor. Overhead expenses
include indirect materials, indirect labor, depreciation, taxes, insurance, rental, and may other expenses.