Eng r Costs and Estimates

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Engineering Economics Engineering Costs

and Cost Estimating

William Loendorf, P.E.


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Engineering Costs

Evaluating a set of feasible alternativesrequires that many costs be analyzed.

Examples include costs for: initialinvestment, new construction, facilitymodification, general labor, parts andmaterials, inspection and quality, training,material handling, fixtures and tooling,data management, technical support, aswell as general support costs (overhead).


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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


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Engineering Costs

For example, in a production environment afixed cost, such as costs for factory floorspaceand equipment, remains the same even thoughthe 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 ofemployees in the factory.

Thus fixed costs are level or constant regardlessof output or activity, and variable costs arechanging and related to the level of output or

activity.


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Fixed, Variable and Total Costs

Example 1

An entrepreneur named DK was considering themoney making potential of chartering a bus totake people from his hometown to an event in alarger city.

DK planned to provide transportation, tickets to

the event, and refreshments on the bus for thosewho signed up.

He gathered data and categorized theseexpenses as either fixed or variable:


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Fixed, Variable and Total CostsExample 1

Bus Rental 80.00$ Event Tickets 12.50$Gas Expense 75.00$ 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 cost0 225.00$ -$ 225.00$5 225.00$ 100.00$ 325.00$10 225.00$ 200.00$ 425.00$15 225.00$ 300.00$ 525.00$

20 225.00$ 400.00$ 625.00$

Fixed Costs Variable Costs

Total costs

$-$200.00

$400.00

$600.00

$800.00

0 5 10 15 20

Volume

C o s t ( $ )

Total cost

Fixed cost


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Profit and Loss Terms

In terms of costs and revenues there arethree possible profit and loss points for abusiness 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


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Profit and Loss


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Breakeven ChartsExample 2

DK developed an overall total cost equation for hisbusiness expenses.

Now DK wants to evaluate the potential to make moneyfrom 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.


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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


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Breakeven ChartsExample 2

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 Region0 225.00$ -$ 225.00$ -$ (225.00)$ Loss

5 225.00$ 100.00$ 325.00$ 175.00$ (150.00)$ Loss10 225.00$ 200.00$ 425.00$ 350.00$ (75.00)$ Loss15 225.00$ 300.00$ 525.00$ 525.00$ -$ Breakeven20 225.00$ 400.00$ 625.00$ 700.00$ 75.00$ Profit25 225.00$ 500.00$ 725.00$ 875.00$ 150.00$ Profit30 225.00$ 600.00$ 825.00$ 1,050.00$ 225.00$ Profit35 225.00$ 700.00$ 925.00$ 1,225.00$ 300.00$ Profit40 225.00$ 800.00$ 1,025.00$ 1,400.00$ 375.00$ Profit

Fixed Costs Variable Costs

Profit-loss breakeven chart

$-

$500.00

$1,000.00

$1,500.00

0 5 10 15 20 25 30 35 40

Volume

C o s t ( $ ) Total cost

Fixed cost

Revenue


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Past (Sunk) Costs andFuture (Opportunity) Costs

Sunk cost - money spent due to a pastdecision. We cannot do anything aboutthese costs. Purchase price paid for a car two years ago.

Opportunity cost - a benefit that isforegone by engaging a resource in a

chosen activity instead of engaging thatsame resource in some other activity. Wemake a choice or decision. Buying lunch instead of gas.


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Which amount is the value at present?Example 3

A distributor of electric pumps must decide whatto do with a "lot" of old electric pumps that waspurchased 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 asthey sit in inventory. The pricing manager has the following

information.


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Which amount is the value at present?Example 3

Price when purchased 7,000$ Sunk cost PStorage costs 1,000.00$ Sunk cost PList price when purchased 9,5$ Old list PaCurrent list price of new pumps$ New list differenAmount offered for pumps 2 years ag$ Foregone opportCurrent price that the pumps could be$ Market value


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Expense Types

Recurring costs known, anticipatedand occurs at regular intervals. Purchasing food, paying rent.

Non-recurring costs - one-of-a-kindevent that occurs at an irregular interval. Emergency maintenance expenses.

Sometimes we attempt to plan for large non-recurring costsby buying insurance. Paying the periodic insurance

premium turns this expense into a recurring cost.


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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?

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)$

Model

Costs

Incremental


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Cash Costs vs. Book Costs

Cash costs - movement of money fromone owner to another - also known as acash flow. Payment this month on an auto loan.

Book cost - cost of a past transactionthat is recorded in an accounting book. Down payment recorded in your

checkbook from last years automobilepurchase.


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Life-cycle Costs

Life-cycle - all the time from the initialconception of an idea to the death of aproduct (process).

Life-cycle costs - sum total of all thecosts incurred during the life cycle.

Life-cycle costing - designing aproduct with an understanding of all thecosts associated with a product duringits life -cycle.


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Product Life-cycle


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Cumulative Life-cycle CostsCommitted and Dollars Spent


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Life-cycle Design Change Costsand Ease of Change


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Cost Estimating

Economic analysis is future based. Costs and benefits in the future require

estimating.

Estimated costs are not known withcertainty. The more accurate the estimate, the

more reliable the decision. Estimating is the foundation of

economic analysis.


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Types of Estimates

There are three general types ofestimates:1. Rough order of magnitude, used for

high level planning, inaccurate, rangefrom -30% to +60% of actual values.

2. Semi-detailed - based on historicalrecords, reasonably sophisticated and

accurate, -15% to +20% of actual values.3. Detailed - based on detailed

specifications and cost models, veryaccurate, within -3% to +5% of actual.


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Accuracy vs. Cost Tradeoff inEstimating


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Estimating Models

Tracking cost improvements.LearningCurve

Looking at costs from severalperspectives.

Triangulation

Scaling previous known costs upor down (economies of scale).

Power Sizing

Index number based on historicalchanges in cost.

Cost Indexes

Divide problem into items,estimate each & sum.

Segmenting

Uses a per unit factor. $/sq ft, Benefits/employee

Per Unit

ExplanationModel Examples

US CPI
http://minneapolisfed.org/economy/calc/cpihome.htmlhttp://minneapolisfed.org/economy/calc/cpihome.html


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Estimating Benefits

So far we have focused on cost terms and costestimating. However, engineering economists must often

also estimate benefits.

Example benefits include sales of products,revenues from bridge tolls and electric powersales, cost reductions from reduced material orlabor costs, reduced time spent in traffic jams,and reduced risk of flooding.

These benefits are the reasons that manyengineering projects are undertaken. The cost concepts and cost estimating models

can also be applied to economic benefits.


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Cash Flow Diagrams

The costs and benefits of engineering projects occurover time and are summarized on a Cash Flow Diagram(CFD).

Specifically, a CFD illustrates the size, sign, and timingof individual cash flows. In this way the CFD is the basisfor engineering economic analysis.

A Cash Flow Diagram is created by first drawing asegmented time-based horizontal line, divided intoappropriate 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 verticalarrow is added - pointing down for costs and up forrevenues or benefits.

These cash flows are drawn to relative scale.


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Cash Flow Diagrams


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Cash Flow Diagrams

Summarizes the flow of money over time Can be represented using a spreadsheet

Year Capital costs O&M Overhaul Total0 (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

$(100,000.00)$(80,000.00)$(60,000.00)$(40,000.00)$(20,000.00)

$-

$20,000.00

0 1 2 3 4 5 6

Ye ar

C a s

h f l o w Overhaul

O&MCapital costs


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Summary This chapter introduced the cost concepts: fixed and

variable, marginal and average, sunk, opportunity,recurring and nonrecurring, incremental, cash andbook, and lifecycle.

Fixed costs are constant and unchanging asvolumes change, while variable costs change asoutput changes.

Fixed and variable costs are used to find thebreakeven value between costs and revenues, aswell as the regions of net profit and loss.

A marginal cost is for one more unit, while theaverage cost is the total cost divided by the number

of units

Eng r Costs and Estimates

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