Engineering Economic Analysis Canadian Edition Chapter 2: Engineering Costs and Cost Estimating.

Engineering Economic AnalysisCanadian Edition

Chapter 2:

Engineering Costs and Cost Estimating

2-2EECE 450 — Engineering Economics

Chapter 2 … Defines cost concepts and engineering cost

estimating. Explains three types of engineering

estimates. Discusses the effect of the learning curve

on cost estimates. Covers models for estimating costs and

benefits. Presents cash flow diagrams to show costs

and benefits.


Engineering Costs Costs: the economic value of the resources

used in the production of goods and services.• Land, labour, capital, and entrepreneurial skills• Initial investment, wages and salaries, material

purchases, utilities

Profits indicate that scarce economic resources are being used properly.• The selling value of the goods and services

produced exceeds the cost of the resources used in their production.

Losses may reflect a waste of resources.


Classification of Costs Fixed: constant and unchanging

• Rent on a building is constant regardless of how much space is utilized.

Variable: depends on activity level• Linear (proportional) or non-linear

Amount of raw material used depends on how many units are made.

Total cost = Fixed cost + Variable cost Marginal cost: variable cost for the next unit. Average cost: total cost per unit =

units of #

MaterialsRent


Fixed, Variable, and Total Costs (Example 2-1)

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

$400

$600

$800

0 5 10 15 20

Volume

Co

st

($)

Total cost

Fixed cost


Costs

OutputTotal Cost

Total Fixed Cost

Total Variable

Cost

Average Fixed Cost

Average Variable

CostAverage

CostMarginal

Cost

1.0 3.0 2.0 1.0 2.00 1.00 3.00 1.0

2.0 3.8 2.0 1.8 1.00 0.90 1.90 0.8

3.0 4.4 2.0 2.4 0.67 0.80 1.47 0.6

4.0 4.8 2.0 2.8 0.50 0.70 1.20 0.4

5.0 5.2 2.0 3.2 0.40 0.64 1.04 0.4

6.0 5.8 2.0 3.8 0.33 0.63 0.97 0.6

7.0 6.6 2.0 4.6 0.29 0.66 0.94 0.8

8.0 7.6 2.0 5.6 0.25 0.70 0.95 1.0

9.0 8.8 2.0 6.8 0.22 0.76 0.98 1.2

10.0 10.2 2.0 8.2 0.20 0.82 1.02 1.4


Total, Variable, and Fixed Costs

Total, Variable, and Fixed Costs

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0

Output (units)

$

TC

TVC

TFC


Average and Marginal Costs

Average and Marginal Costs

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

1.0 2.0 3.0 4.0 5.0 6.0 7.0 8.0 9.0 10.0

Output (units)

$

ACAVCMCAFC


Profit and Loss Terms Total revenue = Unit price units sold Breakeven: total revenue = total costs

• Just getting by

Profit: total revenue > total costs• Putting money in the bank

Loss: total revenue < total costs• Going into debt


Profit and Loss(non-linear cost and revenue)

Total cost

Total revenue

Profit

OutputProfit Zone


Breakeven (Example 2-2)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)$ Loss5 225.00$ 100.00$ 325.00$ 175.00$ (150.00)$ Loss

10 225.00$ 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

$1,000

$1,500

0 5 10 15 20 25 30 35 40

Volume

Co

st

($)

Total cost

Fixed cost

Revenue


Past (Sunk) Costs Sunk cost: money spent due to a past

decision.• We cannot do anything about these costs.

Example: the amount paid to purchase a car two years ago.


Future (Opportunity) Costs Opportunity cost: a benefit that is not realized

when a resource is engaged in one activity instead of engaging that same resource in another foregone activity.• We make a choice or decision.

Example: Buying lunch instead of gas.

Examine each cost and determine what type it is (Example 2-3).

Price when purchased 7,000.00$ Sunk cost Past decisionsStorage costs 1,000.00$ Sunk cost Past decisionsList price when purchased 9,500.00$ Old list Past decisionsCurrent list price of new pumps 12,000.00$ New list different features Past decisionsAmount offered for pumps 2 years ago 5,000.00$ Foregone opportunity Past decisionsCurrent price that the pumps could be sold for 3,000.00$ Market value Present opportunity


Expense Types Recurring expense: anticipated and occurs at

regular intervals.• Purchasing food, paying rent.

Non-recurring expense: one-of-a-kind event that occurs at an irregular interval.• Illness, accident, death.

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 Incremental cost: the difference between the

costs of two alternatives (Example 2-4).

Cost Items A BPurchase 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


Cash versus Book Costs Cash costs: movement of money from one

owner to another.• Also known as a ‘cash flow’.

Payment this month on an auto loan.

Book costs: cost of a past transaction that is recorded in a book.• Down payment recorded in your cheque book from

last year’s automobile purchase.


Life-cycle Costs Life-cycle: all the time from the conception to

the death of a product or process. Life-cycle costs: the sum total of all the costs

incurred during the life-cycle. Life-cycle costing: designing with an

understanding of all the costs associated with a product during its life-cycle.


Phases of Life-cycle Costs

1. Needs assessment and justification

2. Conceptual or preliminary design

3. Detailed design

4. Production or construction

5. Operational use

6. Decline and retirement


Life-cycle Costing In general, the later a product design change

is made, the higher the cost.• Earlier changes are easier and less costly. • Decisions made early in the life-cycle tend to ‘lock-

in’ cost that will be incurred. About 70% to 90% of all costs are committed

during the design phases. Only 10% to 30% of cumulative life-cycle

costs have been spent by the end of the design phase.


Cost Estimating Engineering economic analysis is future

based.• Future consequences (costs and benefits) of

current decisions are analyzed.• Requires estimating.

Estimated costs and benefits are not known with certainty.• The more accurate the estimate, the more reliable

the decision.


Types of Estimates Rough: gut level

• Inaccurate. 30% to +60%.

Semi-detailed: based on historical records• Reasonably sophisticated and accurate. 15% to +20%.

Detailed: based on specifications and cost models• Very accurate. 3% to +5%.

Difficulties arise when the future is uncertain.


Types of Estimates … One-of-a-kind or first time projects

• There are few such projects in engineering economic analysis.Example: First NASA mission.

Resource constraints• Time and human resources.• Quality and accuracy of estimates adversely

affected.

Estimator expertise• Experience and knowledge better quality (and

more reliable) estimates.


Estimating Models

Model Explanation

Per unit Uses a ‘per unit’ factor$/sq ft, Benefits/employee

Segmenting Divide problem into items, estimate each and sum

Cost indexes Index number based on history

Power sizing Scaling previous known costs up or down

Triangulation Looking at costs from several perspectives

Learning curve Tracking cost improvements

Examples

Microsoft Excel

Worksheet

Click the Excel® icon to open a spreadsheet of examples.


In general, as the output doubles, the unit production time will be reduced by a fixed percentage or learning curve rate.• If the 3rd unit took 200 minutes to produce in a

production run with a 90% learning time curve, then the 6th unit will take 200(0.90) = 180 minutes.

Estimating time in repetitive tasks:TN = TInitial Nb

where TN = time required for the Nth unitTInitial = time required for the 1st unit

N = number of completed unitsb = learning curve exponent

Learning Curves


Learning Curve (Example 2-10) A company has a learning curve rate of 85% and a

production run of 20 units. Unit production time is 5.0 minutes when 16 units have been produced. Total production time is 118.8 minutes.

Learning Curve

0.0

2.0

4.0

6.0

8.0

10.0

12.0

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

Units

Pro

du

ctio

n T

ime

(m

inu

tes)


Cash Flow Diagrams Arrows: the usual interpretation is positive for

cash inflows (revenues) and negative for cash outflows (expenses).• The length of the arrow represents the magnitude

($) of the cash flow.

Time dimension: points in time when the positive and negative cash flows occur

Discount factor


Categories of Cash Flows1. First cost ≡ construction, purchase, or

installation expense.2. Operations and maintenance ≡ annual

expense.3. Salvage value ≡ receipt at project

termination.4. Revenues ≡ annual receipts due to sale of

products.5. Overhaul ≡ major capital expenditure

occurring during life of asset.


Cash Flow Diagrams … Cash flow diagrams summarize the flow of

money over time. They 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

Year

Cas

h f

low Overhaul

O&M

Capital costs


Cash Flow: Annuity

Project Cash Flows

-$12,000

-$10,000

-$8,000

-$6,000

-$4,000

-$2,000

$0

$2,000

$4,000

$6,000

0 1 2 3 4 5 6 7 8 9 10

End-of-year

$

End of Year

Cash Flow

0 $10,000

1 $5,000

2 $5,000

3 $5,000

4 $5,000

5 $5,000

6 $5,000

7 $5,000

8 $5,000

9 $5,000

10 $5,000


Irregular Cash Flow

Project Cash Flows

-$15,000

-$10,000

-$5,000

$0

$5,000

$10,000

0 1 2 3 4 5 6 7 8 9 10

End-of-year

$End of Year

Cash Flow

0 $10,000

1 $3,000

2 $2,000

3 $1,000

4 $5,000

5 $6,000

6 $2,000

7 $6,000

8 $3,000

9 $4,000

10 $8,000


Cash Flow: Geometric Series

Project Cash Flows

-$15,000

-$10,000

-$5,000

$0

$5,000

$10,000

$15,000

$20,000

0 1 2 3 4 5 6 7 8 9 10

End-of-year

$

End of Year

Cash Flow

0 $10,000

1 $3,000

2 $3,600

3 $4,320

4 $5,184

5 $6,221

6 $7,465

7 $8,958

8 $10,750

9 $12,899

10 $15,479


Suggested Problems 2-3, 2-7, 2-10, 2-11, 2-20, 2-21, 2-23, 2-24, 2-

26, 2-27, 2-28, 2-31, 2-32, 2-34, 2-35, 2-36, 2-37

Engineering Economic Analysis Canadian Edition Chapter 2: Engineering Costs and Cost Estimating.

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Transcript of Engineering Economic Analysis Canadian Edition Chapter 2: Engineering Costs and Cost Estimating.