Module 3: Cost Estimation Techniques

Recap
2
What is fixed cost and variable cost?
What is direct and indirect cost?
What sunk cost and opportunity cost?
What is cash cost and book cost?
What is life cycle cost ?
What is relationship between price, demand and
total revenue?
What is relationship between profit , revenue and
cost?
How to maximize your profit?
What is breakeven point?
 Overview
3

This chapter presents various

methods for estimating
important factors in an
engineering economy study
 7 Steps in engineering economic analysis procedure
4

 Problem recognition, definition and evaluation

 Development of the feasible alternatives
 Development of outcomes and cash flows for each alternatives
 Selection of a decision criterion
 Analysis and comparison of the alternatives.
 Selection of the preferred alternative.
 Performance monitoring and post-evaluation of results.
 Chapter Objectives
At the end of this chapter, you will be able to:
• Discuss the techniques of cost estimation

• Apply cost analysis in design decision

5
 Cash Flow Estimation

 Engineering economic studies deals with outcomes that extend into the
future
 Estimating the future cash flows for feasible alternatives is a critical step
in engineering economy studies.
 Estimating costs, revenues, useful lives, residual values, and other
pertinent data can be the most difficult, expensive, and time-consuming
part of the study
 Case Study – iPhone X

Apple’s 64GB iPhone X is priced at $1000

(RM3499). Do you know the profit margin for
Apple from selling an iPhone X?

The estimated production cost of the iPhone

X is around $412.75. That's about 59%
cheaper than the $999 retail starting price
for the 64GB model.

How does Apple come up with such an

estimate of various component costs before
pricing their product?

Unsurprisingly, the most expensive part of

the iPhone X is the Samsung-made 5.8-inch
Super Retina display
 Cost Estimation

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.
The costs incurred to generate particular revenue should
be recognized as expenses in the same period that the
revenue is recognized
Cost Estimation Techniques
 “top-down”

Top-down uses historical

data from similar
engineering projects to
estimate cost, revenues
etc. for current project. It
is best used when
alternatives are still being
developed and refined.
 “bottom-up.”
11

Bottom-up is more detailed-breaks down project into

small units & estimates their economic consequences
- works best when the detail concerning the desired
output (product or service) has been defined and
clarified
 12

https://www.youtube.com/watch?v=plZjiY4i4mc
13
14
15
 Integrated Cost Estimation
The integrated approach to developing the net cash flows for
feasible project alternatives has three major components.

 Work breakdown structure (WBS)

 Cost and revenue structure (classification)
 Estimating techniques (models)
Cost Estimation Flowchart
https://www.youtube.com/watch?v=akO2Lf1fHmM

18
 Work Breakdown Structure

Work Breakdown Structure (WBS)

 A basic tool in project
management
 Vital aid in engineering
economy study
 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.
WBS Template
 WBS Characteristics

A WBS has other characteristics.

 Both functional(planning) and
physical(foundation) work elements are
included.
 The content and resource requirements for
a work element are the sum of the activities
and resources of related sub-elements
below it.
 A project WBS usually includes recurring
and nonrecurring work elements.
Example
22
Solution
23
 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.
Costs and revenues for eng. economy study
26
 Estimating Techniques (Models)
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% - 50%)- used in planning & initial
evaluation stage of a project to select the feasible alternatives (L1 or L2)
 Semi-detailed, or budget, estimates (±15%) – used in the preliminary or
conceptual design stage of a project – support decision making during
project period(L2 &L3)
 Definitive (detailed) estimates (±5%)- used in the detailed
engineering/construction stage of a project (L3)
 Estimation Details

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.
 Estimation Data

A variety of sources exist 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: U.S.
government data, industry surveys,
trade journals, and personal contacts.
 Research and development: e.g., pilot
plant, test marketing program,
surveys.
 Estimation Models

These models can be used in many types of estimates.

 Indexes
 Unit technique
 Factor technique
 32

https://www.youtube.com/watch?v=YQ2Wi3Jh3X0
 Cost-Price Index

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).
 Exercise
34

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.
Solution
35
 Exercise 1 – Costs

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?

Cost of the new pump (using eq. 3-1)

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.
 Unit Cost-Price

The unit technique is one that is 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.
 Example 4 – Ice-cream Costs

 Breakdown of unit cost items  Product costs

 Period costs
 Factor Cost-Price

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
Example
40
41
42
43
 Parametric Cost-Price

 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).
45
 Case Study 1 – Power Sizing
The power-sizing technique (or exponential model) is frequently
used for developing capital investment estimates for industrial
plants and equipment – cost varies as some power of the change in
capacity or size.

(both in $ as of the point in time for which

the estimate is desired)

(both in the same physical units)

 Exercise 2 – Costs

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?

Cost of the new hub (using eqs. 3-1 and 3-4)

48
Exercise
49
50
 Case Study 2 – 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.
Most learning curves assume a constant percentage reduction
occurs as the number of units produced is doubled.
 Exercise 3 – Learning Curve

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.
Exercise
53
54
 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
 Summary
56

 Engineering economic analysis require cash flow

projection to determine worthiness of engineering projects.

 Integrated cash flow analysis must include (1) WBS

definition, (2) cost revenue structure, (3) estimation
techniques.

 estimating techniques form a bridge between the WBS and

detailed cost and revenue data and the estimated cash
flows for the alternatives.
 57

https://www.youtube.com/watch?v=gY1RNbOVRrU