Cost Estimation

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CHAPTER 7

• Cost Estimation

2
Review

• General Problem Solving Skills
• Moving Money through Time (Equivalence Models)
• Developing Estimates of Future Cash Flows
• Using Cash Flows to Compute Various Measures of
  Economic Merit before and after tax

• Chapter 2
• Chapter 3
• Chapter 7
• Chapter 4, 5, and 6

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Cost Estimation

• What is estimating?
• A forecast, a best guess, a projection into the
  future
• For the most part, Engineers generally have the
  responsibility of cost estimation
• Future costs are very critical to the analysis of
  a project
• Revenue generation generally comes from marketing
  or sales areas

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Applications

• What is the purpose of estimating?
• quoting, bidding, or evaluating bids
• profitability analysis
• basis for make versus buy decisions
• investment justification
• basis for comparing manufacturing methods
• basis for cost reduction
• planning new products and services
• All these involve developing cash flows for
  feasible alternatives

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Costs to Estimate

• What costs are to be estimated?
• First cost elements
• Equipment cost
• Delivery charges
• Installation costs
• Insurance costs (premiums)
• Training of personnel for equipment use.
• The first important cost
• Given the interest rate and the estimated life of
  the asset
• Calculate the Capital Recovery Costs

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Annual Operating Cost Estimation

• Estimate the AOC using
• Direct Labor Costs
• Direct materials costs
• Periodic maintenance costs
• Rework and rebuilt
• Other costs could be
• On-line testing and calibration
• Proofing runs before actual production.

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Work Breakdown Structure (WBS)

• The WBS technique organizes activities into a
  hierarchical structure based on either functional
  or physical categories
• See Figures 7-2 and 7-3
• WBS - Organizational Schemes
• Functional
• Logistical Support, Project Management,
  Marketing, Engineering, System Integration
• Physical
• Products, Outputs, or Parts that make up the
  structure

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WBS-Tabular Format

• 1.0 Commercial Building Project
• 1.1 Site Work and Foundation
• 1.1.1 Site Grading
• 1.1.2 Excavation
• 1.1.3 Sidewalks/Parking
• 1.1.4 Footing/Foundation
• 1.1.5 Floor Slab
• 1.2 Exterior
• 1.2.1 Framing
• 1.2.2 Siding
• 1.2.3 Windows
• 1.2.4 Entrances
• 1.2.5 Insulation

• 1.3 Interior
• 1.3.1 Framing
• 1.3.2 Flooring/Stairways
• 1.3.3 Walls/Ceilings
• 1.3.4 Doors
• 1.3.5 Special Additions

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Cost Estimation Approaches

• Bottom-Up Approach
• Treats the final cost as an independent (output)
  variable and the associated costs as input or
  dependent variables
• Top-Down Approach
• Treats the competitive cost as an input variable
  and the associated cost estimates as the output
  variables
• Also called Design-to-Cost Approach

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Two Cost Estimating Approaches
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Bottom-Up Approach

• Treats the final cost as an independent (output)
  variable and the associated costs as input or
  dependent variables.
• Cost components are first identified
• Cost elements are estimated
• Price DC TIDC Profit
• Traditional costing approach
• Applied in industries where competition is not
  the dominant factor in pricing the product or the
  service

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Top-Down Approach

• Treats the competitive cost as an input variable
  and the associated cost estimates as the output
  variables.
• Applied in the early stages of new or enhanced
  product design
• Price estimates are conducted to set target
  values
• Detailed design and equipment needs are not yet
  defined
• Becoming more popular especially in high
  competition markets
• Places greater emphasis on the accuracy of the
  estimation process
• Common practice in Eastern cultures (Japan and
  other Asian countries)

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Accuracy of Estimates

• NO estimate is intended to be exact
• But must be reasonable and accurate enough to
  provide a robust economic analysis.
• In Preliminary Design Phase
• Estimates are viewed as first cut estimates.
• Serve as inputs to the project initial budget.
• The unit method is often applied here
• Accepted Range of Accuracy
• Per Unit approaches should fall into the ?5 to
  ?15 range for total costs
• Estimates outside of the ?15 range are not
  reliable!

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Cost Estimation Techniques

• Expert Opinion
• Past experience in the field
• Cost Indexes where available
• Cost Estimating Relationships (forms of
  regression analysis based upon historical data)
• Combinations of the above.

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Cost Index

• Cost Index is a ratio of a cost NOW to some cost
  back in time.
• The index is a dimensionless number.
• Example The Consumer Price Index (CPI)
• Cost Index Notation
• IN Index for some current year, N
• Ik Index for some base year, k
• Ck cost of some item during base year
• CN Ck ( IN / Ik )
• CN cost of the item during the current year

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Sources

• Chemical Engineering plant cost index
• Engineering News Record
• Marshall Swift equipment cost index
• Many others
• Most are web-based but require a subscription
  fee to access detailed values

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Index Example

• Need to estimate skilled labor for a construction
  project
• 5 years ago the cost was documented to be
  360,000.
• Skilled labor index then was 3,496.27.
• Today the index is 4,038.44.
• What is the estimated labor cost today based upon
  this information?
• CN Ck ( IN / Ik )

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Warnings to Heed

• For manufacturing and servicing industries
  tabulated cost indexes are not readily available
• Cost indexes may vary with the region of the
  country
• Cost indexes are very sensitive over time to
  technological changes.

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Development of Cost Index-Example

• A manufacturing engineer with Hughes Industries
  is interested in estimating the cost of plant
  expansion. Two items used in the manufacturing
  process are A and 2. Consulting through
  Purchasing Department, he found the following
  historical data. Make the first quarter of 2001
  the base period, and determine the cost indexes
  using a basis of 100.
• Year 1999 2000 2001 2002
• Quarter Q1 Q2 Q1 Q2 Q1 Q2 Q1
• --------------------------------------------------
  ------------------------------------------------
• Item A, /unit 57.00 56.90 56.90 56.70 56.60 56.40
  56.25
• Item B, /Unit 446 450 455 575 610 625 635

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Solution

• For each item, the index (IN/Ik) is calculated
  with the firs-quarter 2001 cost used for the Ik
  value
• Year 1999 2000 2001 2002
• Quarter Q1 Q2 Q1 Q2 Q1 Q2 Q1
• --------------------------------------------------
  ------------------------------------------------
• Item A cost index 100.71 100.53 100.53 100.17 100.
  00 99.65 99.38
• Item B cost index 73.11 73.77 74.59 94.26 100.00 1
  02.46 104.10
• ((56.60-56.60)/56.60 )100100

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The Unit Technique

• Unit Method
• Popular, Very preliminary in nature, Multiply the
  number of units times a per unit cost factor.
• Examples
• Cost per operating mile (autos, trucks, etc.),
  Cost of construction (per sq. foot), Cost per
  mile (highways, cable, etc.)

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The Factor Technique

• An extension of the unit method
• Originally developed for estimating total plant
  costs
• Identify the major equipment items, then multiply
  by certain factors
• Sum of products of component quantities and
  corresponding unit costs plus component costs
  estimated directly
• C S dCd S mfmUm
• C cost being estimated
• Cd cost of d estimated directly
• fm cost per unit of m
• Um number of units of m

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Example

• Estimate the cost of a house consisting of 2,000
  sq, two porches, and a garage. Using unit factor
  of 50 per sq, and 5,000 per porch and 8,000
  per garage.
• C S dCd S mfmUm
• C(5,0002)8000(502000)118,000

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Cost Estimating Relationships ( CER )

• CERs use design variables to predict costs.
• CERs are more quantitative in nature than cost
  indexes.
• Developed from statistical approaches
• Usually linear or non-linear regression models.
• A common model Cost-Capacity Model
• A model that relates the cost of an asset or
  activity to its capacity
• Called also power-sizing

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The Power-Sizing Technique

• Also referred to as exponential model
• Used for costing plants and equipment
• Recognizes that cost varies as some power of the
  change in capacity or size
• Example
• (CA / CB) (SA / SB)X
• CA CB(SA / SB)X
• CA Cost of plant A CB Cost of plant B
• SA Size of plant A SB Size of plant B
• X cost-capacity factor (reflects economies of
  scale)

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The Exponent in the CCE - x

• Normally 0 ltxlt1
• For x lt 1 the economies of scale are applied.
• For x 1, the model is linear.
• For x gt 1, a larger size is expected to be more
  costly than a linear model.
• If x is unknown, common to assume x 0.6
• The Chemical Engineering area has well documented
  CCE parameters.
• Other sources
• Plant Design and Economics for Chemical
  Engineers
• Chemical Engineers Handbook
• EPA publications
• Equipment companies.

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The Learning and Experience Technique

• Learning curve is a mathematical model that
  explains increased worker efficiency and improved
  performance from repetitive production
• Most learning curves are based on the assumption
  that the number of input resources needed
  decreases by a constant percentage each time the
  number of units produced doubles.
• Zu Kun
• u the output unit number
• Zu resource units to produce output unit u
• K resource units to produce 1st output unit
• s learning-curve slope parameter (decimal)
• n log s / log 2

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Example

• It has been determined that a 90 learning curve
  applies to a particular assembly operation. It
  takes 30 minutes to assemble the first unit. How
  many minutes are required to produce the 5th
  unit? the 30th unit?
• n log (0.9) / log (2) -0.152
• Z 5 30(5) -0.152 23.49 minutes
• Z 30 30(30) -0.152 17.89 minutes

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Other Computations

• Tu cumulative time to produce u units K?un
• Cu cumulative average for u units Tu/u
• Continuing our example,
• T5 301 -0.152 2 -0.152 3 -0.152 4 -0.152
  5 -0.152 130.18 minutes
• C5 T5/5 130.18/5 26.04 minutes per unit

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Another Example

• A construction Company designs and builds
  residential family homes. The company is ready to
  construct, in sequence, 16 new homes of 2400
  square feet each. The same basic design, with
  minor changes, will be used for each home. The
  successful bid for the construction materials in
  the first home is 64,800, or 27/square foot.
  The manger believes, based on past experience,
  that several actions can be taken to reduce
  material cost by 8 each time the number of homes
  constructed doubled. Based on this information,
  (a) what is the estimated cumulative average
  material cost per square foot for the first
  homes, and (b) what is the estimated material
  cost per square foot for the last 16th home?

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Manufacturing Cost Estimating

• Objective
• To make a product that can be sold at a
  competitive price yet yields a reasonable profit.
• Determining Selling Price
• To estimate the cost of a manufactured product,
  you need a product design and process plan to
  compute direct labor hours and material costs
• A cost estimating worksheet or spreadsheet (e.g.,
  Figure 8-5) is a useful tool for this.

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Cost Accounting Overview

• Costs incurred within a system are tracked by the
  cost accounting system
• Cost accounting system accumulates
• Material costs, Labor costs, and Indirect costs
  (overhead or factory expense)
• And allocates these cost to defined cost centers.
• A difficult problem, when required, is to
  properly allocate the IDCs to the various cost
  centers, departments, processes, and product
  lines.
• Cost centers do utilize a portion of the total
  indirect costs
• Thus, some allocation scheme needs to be applied
  to the cost centers

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Traditional IDC Allocations
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Summary

• Cost estimation is not an exact science
• Estimates should be accurate enough to support
  robust engineering economy cost analysis
• Two Approaches (Treat costs differently)
• Bottom-Up and Top-Down
• Cost Indexes are used to estimate and update
  costs
• Cost Estimating
• Cost-Capacity Equations,
• Cost estimation from design variables for
  material, equipment, and construction.
• Factor Method
• Used to estimate total plant costs.