Engineering Economics

Engineering Costs
and Cost Estimating

1
Engineering Costs

 Evaluating a set of feasible alternatives requires that many costs be

analyzed.
 Examples include costs for: initial investment, new construction,
facility modification, general labor, parts and materials, inspection
and quality, training, material handling, fixtures and tooling, data
management, technical support, as well as general support costs
(overhead).
Engineering Costs

Classifications of costs
 Fixed - constant, unchanging
 Rent is constant (single, married, children)
 Typically includes building leases, insurance, salaries, heating, and lighting costs.
 Variable - depend on activity level
 Food depends on the number of occupants
 Typically vary with the level of production.
 Marginal - variable cost for the next unit
 Depends on the next unit (adult, child, baby)
 Average - total cost/number of units
 Rent+ food+…+n/number of units
Engineering Costs

 For example, in a production environment a fixed

cost, such as costs for factory floorspace and
equipment, remains the same even though the
production quantity, number of employees, or level
of work-in-process are varying.
 Labor costs are classified as a variable cost
because they depend on the number of
employees in the factory.
 Thus fixed costs are level or constant regardless of
output or activity, and variable costs are changing
and related to the level of output or activity.
Fixed, Variable and Total Costs

Example 1
 An entrepreneur named DK was considering
the money making potential of chartering a bus
to take people from his hometown to an event
in a larger city.
 DK planned to provide transportation, tickets to
the event, and refreshments on the bus for
those who signed up.
 He gathered data and categorized these
expenses as either fixed or variable:
 Fixed, Variable and Total Costs
Example 1
Fixed Costs Variable Costs
Bus Rental $ 80.00 Event Tickets $ 12.50
Gas Expense $ 75.00 Refreshments $ 7.50
Other Fuels $ 20.00 Total costs
Bus Driver $ 50.00
Total FC $ 225.00 Total VC $ 20.00 $800.00
$600.00

Cost ($)
Total cost
$400.00
Fixed cost
People Fixed cost Variable cost Total cost $200.00
0 $ 225.00 $ - $ 225.00 $-
5 $ 225.00 $ 100.00 $ 325.00
0 5 10 15 20
10 $ 225.00 $ 200.00 $ 425.00
15 $ 225.00 $ 300.00 $ 525.00 Volume
20 $ 225.00 $ 400.00 $ 625.00
Profit and Loss Terms

 In terms of costs and revenues there are three

possible profit and loss points for a business activity.
 Breakeven: total revenue = total costs
 Just getting along
 Profit region: total revenue > total costs
 Putting money in the bank
 Loss region: total revenue < total costs
 Going into debt
Profit and Loss
Breakeven Charts

Example 2
 DK developed an overall total cost equation for his business
expenses.
 Now DK wants to evaluate the potential to make money from
this chartered bus trip.
Total Cost = Total Fixed Cost + Total Variable Cost
= $225 + ($20)(the number of people on the trip)
 Let x = number of people on the trip
 Thus,
Total Cost = 225 + 20x

 Using this relationship, DK can calculate the total cost for any
number of people - up to the capacity of the bus.
Breakeven Charts

 What he lacks is a revenue equation to offset his costs.

 DK's total revenue from this trip can be expressed as:
Total Revenue =
= (Charter ticket price)(number of people on the trip)
= (ticket price)(x)

 Profit or loss can now be calculated as:

Total Profit =
= [Total Revenue] - [Total Costs]
= [ticket price]x – [225 + 20x]
If he charged a charter ticket price of $35, then
= [35x] - [225 + 20x]
= 15x - 225
 Breakeven Charts
Example 2
Fixed Costs Variable Costs Ticket price
Bus Rental $ 80.00 Event Tickets $ 12.50 $ 35.00
Gas Expense $ 75.00 Refreshments $ 7.50
Other Fuels $ 20.00
Bus Driver $ 50.00
Total FC $ 225.00 Total VC $ 20.00

People Fixed cost Variable cost Total cost Revenue Profit Region
0 $ 225.00 $ - $ 225.00 $ - $ (225.00) Loss
5 $ 225.00 $ 100.00 $ 325.00 $ 175.00 $ (150.00) Loss
10 $ 225.00 $ 200.00 $ 425.00 $ 350.00 $ (75.00) Loss
15 $ 225.00 $ 300.00 $ 525.00 $ 525.00 $ - Breakeven
20 $ 225.00 $ 400.00 $ 625.00 $ 700.00 $ 75.00 Profit
25 $ 225.00 $ 500.00 $ 725.00 $ 875.00 $ 150.00 Profit
30 $ 225.00 $ 600.00 $ 825.00 $ 1,050.00 $ 225.00 Profit
35 $ 225.00 $ 700.00 $ 925.00 $ 1,225.00 $ 300.00 Profit
40 $ 225.00 $ 800.00 $ 1,025.00 $ 1,400.00 $ 375.00 Profit

Profit-loss breakeven chart

$1,500.00
Total cost
Cost ($)

$1,000.00
Fixed cost
$500.00
Revenue
$-
0 5 10 15 20 25 30 35 40
Volume
Breakeven Point

It is the output level at which total revenue is equal to total cost.

@ Break-even:
REVENUE = FC + VC
Selling Price x Unit = FC + vc per unit
BEP (in units) = FC/(SP-VC)
Example 2 : DK
BEP = 225/(35-20)
= 15 units
 Past (Sunk) Costs and
Future (Opportunity) Costs

 Sunk cost - money spent due to a past decision. We cannot do

anything about these costs.
 Purchase price paid for a car two years ago.
 Opportunity cost - a benefit that is foregone by engaging a resource
in a chosen activity instead of engaging that same resource in some
other activity. We make a choice or decision.
 Buying lunch instead of gas.
Which amount is the value at present?

Example 3

 A distributor of electric pumps must decide

what to do with a "lot" of old electric pumps
that was purchased 3 years ago.
 Soon after the distributor purchased the lot,
technology advances were made.
 These advances made the old pumps less
desirable to customers.
 The pumps are becoming more obsolescent as
they sit in inventory.
 The pricing manager has the following
information.
Which amount is the value at present?

Example 3
Price when purchased $ 7,000.00 Sunk cost Past decisions
Storage costs $ 1,000.00 Sunk cost Past decisions
List price when purchased $ 9,500.00 Old list Past decisions
Current list price of new pumps $ 12,000.00 New list dif erent features Past decisions
Amount offered for pumps 2 years ago $ 5,000.00 Foregone opportunity Past decisions
Current price that the pumps could be sold for $ 3,000.00 Market value Present opportunity
Expense Types

 Recurring costs – known, anticipated and occurs at regular

intervals.
 Purchasing food, paying rent.
 Non-recurring costs - one-of-a-kind event that occurs at an
irregular interval.
 Emergency maintenance expenses.

Sometimes we attempt to plan for large non-recurring costs

by buying insurance. Paying the periodic insurance
premium turns this expense into a recurring cost.
Incremental Costs

 An incremental cost is the difference between the costs of two

alternatives.
Example 4
 Choose between alternative models A and B. What incremental
costs occur with model B?
Costs
Model
Incremental
Cost Items A B
Purchase price $ 10,000.00 $ 17,500.00 $ 7,500.00
Installation costs $ 3,500.00 $ 5,000.00 $ 1,500.00
Annual maintenance costs $ 2,500.00 $ 750.00 $(1,750.00)
Annual utility expenses $ 1,200.00 $ 2,000.00 $ 800.00
Disposal costs after useful life $ 700.00 $ 500.00 $ (200.00)
 Cash Costs vs. Book Costs

 Cash costs – the movement of money from one owner to another - also
known as a cash flow.
- a cost that involves payments in cash or cash transactions.
 Payment this month on an auto loan in cash.

 Book cost – the cost of a past transaction recorded in an accounting book.

- is not a cash flow, but it is an accounting entry that represents

the amortization of past expenditures for items of lengthy

durability.
Cash Costs vs. Book Costs

 Book cost Example:

 Down payment recorded in your checkbook from last year’s
automobile purchase.
 When a company records a depreciation charge of $4
million in a tax year, no money changes hands. However, the
company is saying in effect that the market value of its
physical, depreciable assets has decreased by $4 million
during the year.
Life-cycle Costs

 Life-cycle - all the time from the initial conception

of an idea to the death of a product (process).
 Life-cycle costs - sum total of all the costs incurred
during the life cycle.
 Life-cycle costing - designing a product with an
understanding of all the costs associated with a
product during it’s life-cycle.
Product Life-cycle
Cumulative Life-cycle Costs
Committed and Dollars Spent
Life-cycle Design Change Costs
and Ease of Change
Cost Estimating

 Economic analysis is future based.

 Costs and benefits in the future require estimating.
 Estimated costs are not known with certainty.
 The more accurate the estimate, the more reliable the decision.
 Estimating is the foundation of economic analysis.
Types of Estimates

There are three general types of estimates:

1. Rough – order of magnitude, used for high level
planning, inaccurate, range from -30% to +60% of
actual values.
2. Semi-detailed - based on historical records,
reasonably sophisticated and accurate, -15% to
+20% of actual values.
3. Detailed - based on detailed specifications and
cost models, very accurate, within -3% to +5% of
actual.
Accuracy vs. Cost Tradeoff in Estimating
 Estimating Models

Model Explanation Examples

Per Unit Uses a “per unit” factor.
$/sq ft, Benefits/employee
Segmenting Divide problem into items, estimate each
& sum.
Cost Indexes Index number based on historical US CPI
changes in cost.
Power Sizing Scaling previous known costs up or
down (economies of scale).
Triangulation Looking at costs from several
perspectives.
Learning Curve Tracking cost improvements.
Estimating Benefits

 So far we have focused on cost terms and cost

estimating.
 However, engineering economists must often
also estimate benefits.
 Example benefits include sales of products,
revenues from bridge tolls and electric power
sales, cost reductions from reduced material or
labor costs, reduced time spent in traffic jams,
and reduced risk of flooding.
 These benefits are the reasons that many
engineering projects are undertaken.
 The cost concepts and cost estimating models
can also be applied to economic benefits.
INVESTMENT, WORKING CAPITAL AND
CONTINGENCIES

INVESTMENTS
The total of the first cost and the working capital which is being
put up in a project with the aim of getting a profit.

WORKING CAPITAL
The amount of money set aside as part of the investment to keep
the project or business continuously working.

CONTINGENCIES or CONTINGENCY BUDGET

The amount of money that is included to cover potential events
that are not specifically accounted for in a cost estimate.
DEPRECIATION VS AMORTIZATION

Both methods are used in calculating the

value of business assets over time.

DEPRECIATION
The decrease in the book value of a fixed asset (physical property)
due to the passage of time and obsolescence.

AMORTIZATION
- it is a method for decreasing an asset cost over a period of time.
- It is the manner of liquidating a debt by installment usually at equal
intervals of time.
DEPRECIATION VS AMORTIZATION

Amortization spreads the cost of intangible assets, like

patents, over their useful life.
I
Example: A company acquiring a software license worth Php
500,000, which will be valid for 10 years. Since the software is an
intangible asset, the company should amortize it over the 10-year
period. Using the Straight-Line Method, the annual amortization
expense would be Php 50,000 (Php 500,000/10 years), meaning the
asset’s value decreases by Php 50,000 every year.
DEPRECIATION VS AMORTIZATION

Depreciation, on the other hand, is used for tangible

assets, like machinery, to account for their gradual
wear and tear.

For example, if a company purchases a vehicle worth

Php 1,200,000 with a 6-year useful life, the annual
depreciation would be Php 200,000 (Php 1,200,000/6
years), reducing the asset’s value by Php20,000 yearly.
 MARKET VALUE VS BOOK VALUE

MARKET VALUE
It is the price that is currently offered for an asset in the marketplace

BOOK VALUE
The value of an asset based on the asset’s initial cost adjusted for
any related depreciation, amortization or impairment costs.
THE LAW OF DIMINISHING RETURN

LAW OF DIMINISHING RETURN

It is an economic principle stating that as investment in
a particular area increases, the rate of profit from that
investment, after a certain point, can't continue to
increase if other variables remain constant.
Cash Flow Diagrams
Cash Flow Diagrams

 The costs and benefits of engineering projects occur

over time and are summarized on a Cash Flow Diagram
(CFD).
 Specifically, a CFD illustrates the size, sign, and timing of
individual cash flows. In this way the CFD is the basis for
engineering economic analysis.
 A Cash Flow Diagram is created by first drawing a
segmented time-based horizontal line, divided into
appropriate time units.
 The time units on the CFD can be years, months, quarters
or any other consistent time unit.
 Then at each time when there is a cash flow, a vertical
arrow is added - pointing down for costs and up for
revenues or benefits.
 These cash flows are drawn to relative scale.
Cash Flow Diagrams

Summarizes the flow of money over time

Can be represented using a spreadsheet
Year Capital costs O&M Overhaul Total
0 $ (80,000.00) $ (80,000.00)
1 $ (12,000.00) $ (12,000.00)
2 $ (12,000.00) $ (12,000.00)
3 $ (12,000.00) $ (25,000.00) $ (37,000.00)
4 $ (12,000.00) $ (12,000.00)
5 $ (12,000.00) $ (12,000.00)
6 $ 10,000.00 $ (12,000.00) $ (2,000.00)

Cash flow

$20,000.00
$-
Cash flow

$(20,000.00) 0 1 2 3 4 5 6 Overhaul
$(40,000.00) O&M
$(60,000.00) Capital costs
$(80,000.00)
$(100,000.00)
Ye ar
Summary

 This chapter introduced the cost concepts: fixed and variable,

marginal and average, sunk, opportunity, recurring and
nonrecurring, incremental, cash and book, and lifecycle.
 Fixed costs are constant and unchanging as volumes change,
while variable costs change as output changes.
 Fixed and variable costs are used to find the breakeven value
between costs and revenues, as well as the regions of net
profit and loss.
 A marginal cost is for one more unit, while the average cost is
the total cost divided by the number of units.