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Engineering Economics

Engineering Costs
and Cost Estimating

William Loendorf, P.E.

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
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
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 - movement of money from


one owner to another - also known as a
cash flow.
Payment this month on an auto loan.
Book cost - cost of a past transaction
that is recorded in an accounting book.
Down payment recorded in your checkbook
from last years automobile purchase.
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
its 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. Microsoft Excel

$/sq ft, Benefits/employee


Worksheet

Segmenting Divide problem into items, Microsoft Excel


Worksheet

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.
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
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
C a s h f lo w

$-
$(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.