INDE/EGRM 6617-02

Engineering Economy and Cost Estimating

Chapter 1: Introduction to Engineering Economy

Chapter 2: Cost Concepts and Design Economics
Chapter 3: Cost Estimation Techniques

Dr. Alireza Namdari

anamdarikhalilabad@newhaven.edu
Engineering economy…
answers the basic question of any design: Do its
benefits exceed its costs?
involves the systematic evaluation of the
economic merits of proposed solutions to
engineering problems.
is the dollars-and-cents side of the decisions that
engineers make or recommend as they work to
position a firm to be profitable in a highly
competitive marketplace.
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 Engineering economic
analysis (Examples)
• Choosing the best design for a high-efficiency gas
furnace.
• Selecting the most suitable robot for a welding
operation on an automotive assembly line.
• Making a recommendation about whether jet
airplanes for an overnight delivery service should
be purchased or leased.
• Determining the optimal staffing plan for a
computer help desk.

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The Principles of Engineering
Economy.

1. Develop the alternatives

Carefully define the problem! Then the choice (decision)
is among alternatives. The alternatives need to be
identified and then defined for subsequent analysis.

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2. Focus on the differences
Only the differences in expected future outcomes
among the alternatives are relevant to their comparison
and should be considered in the decision.

3. Use a consistent viewpoint

The prospective outcomes of the alternatives, economic
and other, should be consistently developed from a
defined viewpoint (perspective).

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4. Use a common unit of measure
Using a common unit of measurement to enumerate as
many of the prospective outcomes as possible will
simplify the analysis of the alternatives.

5. Consider all relevant criteria

Selection of the preferred alternative (decision making)
requires the use of a criterion. The decision process
should consider both the outcomes enumerated in the
monetary unit and those expressed in some other unit of
measurement or made explicit in a descriptive manner.

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6. Make uncertainty explicit
Risk and uncertainty are inherent in estimating the
future outcomes of the alternatives and should be
recognized in their analysis and comparison.

7. Revisit your decisions

Improved decision-making results from an adaptive
process; to the extent practicable, the initial projected
outcomes of the selected alternatives should be
subsequently compared with actual results achieved.
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Engineering Economic
Analysis Procedure
• Problem recognition, definition, and evaluation
• Development of the feasible alternatives
• Development of the outcomes and cash flows
for each alternative
• Selection of a decision criterion
• Analysis and comparison of the alternatives
• Selection of the preferred alternative
• Performance monitoring and post-evaluation
of results.
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 Costs can be categorized in several
different ways.
• Fixed cost: unaffected by changes in activity level over a
feasible range of operations for the capacity or capability
available.
Examples: insurance and taxes on facilities, general management and administrative salaries,
license fees.

• Variable cost: varies in total with the quantity of output or

similar measure of activity.
Examples: the costs of material and labor used in a product or service.

• Incremental cost: additional cost resulting from increasing

output of a system by one (or more) units.
Examples: the incremental cost per mile for driving an automobile, incremental cost of
producing a barrel of oil, incremental cost to the state for educating a student.
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 Example
In connection with surfacing a new highway, a contractor has a choice of two sites on
which to set up the mixing plant equipment. The contractor estimates that it will cost
$2.75 per cubic yard mile to haul the asphalt paving material from the mixing plant to
the job site. The job requires 50,000 cubic yards of mixed asphalt paving material. It is
estimated that four months (17 weeks of 5 working days/week) will be required for the
job. If site B is selected, there will be an added charge of $150 per day for a flagman.
Cost Factor Site A Site B
Average hauling distance 4 miles 3 miles
Monthly rental of site $2,000 $7,000
Cost to setup and remove equipment $15,000 $50,000
Hauling expense $2.75/yd^3-mile $2.75/yd^3-mile
a) Compare the two sites in terms of their fixed, variable, and total costs.
b) For the selected site, how much profit can be made if it is paid $11.15 per cubic yard
delivered to the job site?
c) For the selected site, how many cubic yards of paving material does the contractor
have to deliver before starting to make a profit if paid $12 per cubic yard delivered to
the job location?
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 Solution
Cost Fixed Variable Site A Site B
Rent * $8,000 $28,000
Setup/removal * $15,000 $50,000
Flagperson * $0 5(17)($150)=$12,750
Hauling * 4(50,000)($2.75)=$550,000 3(50,000)($2.75)=$412,500
Total $573,000 $503,250

b)
Profit = Revenue - Total cost
Revenue = $11.15 * 50,000 = $557,500
Profit = $557,500 - $503,250 = $54,250
c)
3($2.75) = $8.25 in variable cost per 𝑦𝑑 3 delivered
Total cost = Total revenue
$90,750 + $8.25X = $12X
X = 24,200 yd^3 delivered
Therefore, by using Site B, the contractor will begin to make a profit on the
job after delivering 24,200 cubic yards of material.
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More ways to categorize costs
• Direct: can be measured and allocated to a
specific work activity.
Example: the labor or material costs directly associated with a product, service, or
construction activity.

• Indirect: allocated through a selected formula

to a specific output or work activity.
Example: the costs of common tools, general supplies, and equipment maintenance
in a plant.

• Standard cost: cost per unit of output,

established in advance of production or service
delivery (planned costs per unit of output).
Example: the cost anticipated from labor hours.
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We need to use common cost terminology.
• Cash cost: a cost that involves a payment of cash.
• Book cost: a cost that does not involve a cash
transaction but is reflected in the accounting system.
• Sunk cost: a cost that has occurred in the past and has
no relevance to estimates of future costs and revenues
related to an alternative course of action. It is not part of
the future cash flows and can be disregarded in an
engineering economic analysis.
• Opportunity cost: the monetary advantage foregone
due to limited resources. The cost of the best rejected
opportunity.
• Life-cycle cost: the summation of all costs related to a
product, structure, system, or service during its life span.
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The general price-demand relationship
The demand for a product or service is
directly related to its price according to

𝑝 = 𝑎 − 𝑏𝐷

𝑎−𝑝
𝐷=
𝑏

where p is price, D is demand, and a

and b are constants that depend on the
particular product or service.

Competition?
Monopoly?
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Total revenue depends on price and demand.

Total revenue is the product of the selling price per unit, p, and the
number of units sold, D.

Total Revenue = Price * Demand

𝑇𝑅 = 𝑎 − 𝑏𝐷 𝐷 = 𝑎𝐷 − 𝑏D2

𝑎
𝑓𝑜𝑟 0 ≤ 𝐷 ≤ 𝑎𝑛𝑑 𝑎 > 0, 𝑏 > 0
𝑏
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Total cost is the summation of fixed and
variable costs

Total Cost = Fixed Cost + Variable Cost

𝐶𝑇 = 𝐶𝐹 + 𝐶𝑉

𝐶𝑉 = 𝑐𝑣 . 𝐷
𝑤ℎ𝑒𝑟𝑒 𝑐𝑣 𝑖𝑠 𝑡ℎ𝑒 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡 𝑝𝑒𝑟 𝑢𝑛𝑖𝑡

𝐶𝑇 = 𝐶𝐹 + 𝑐𝑣 . 𝐷
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We can also find maximum profit…
Profit (loss) = Total Revenue – Total Costs
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 − 𝐶𝑇

𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑎𝐷 − 𝑏D2 − 𝐶𝐹 + 𝑐𝑣 . 𝐷 = −𝑏D2 + 𝑎 − 𝑐𝑣 𝐷 − 𝐶𝐹

Differentiating, we can find the value of D that maximizes profit.

𝑑 𝑃𝑟𝑜𝑓𝑖𝑡
= −2𝑏𝐷 + 𝑎 − 𝑐𝑣 = 0
𝑑𝐷
𝑎 − 𝑐𝑣
D∗ =
2𝑏
D∗ : Optimal Demand

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And we can find revenue/cost breakeven.

Breakeven is found when:

Total Revenue = Total Cost
𝑎𝐷 − 𝑏D2 = 𝐶𝐹 + 𝑐𝑣 . 𝐷
Solving, we find the demand at
which this occurs.

− 𝑎 − 𝑐𝑣 ± 𝑎 − 𝑐𝑣 2 − 4(−𝑏)(−𝐶𝐹 )
D′ =
−2b
D1 ′ , D2 ′ : 𝑅𝑎𝑛𝑔𝑒 𝑜𝑓 𝑝𝑟𝑜𝑓𝑖𝑡𝑎𝑏𝑙𝑒 𝑑𝑒𝑚𝑎𝑛𝑑
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 Example
Acme Manufacturing is a major player in the lawn sprinkler
business. Their high-end sprinkler is used commercially, and is
quite popular with golf course greens keepers. In producing
these sprinklers Acme’s fixed cost (𝐶𝐹 ) is $55,000 per month
with a variable cost (𝑐𝑣 ) of $15.50 per unit. The selling price for
these high-end sprinklers is described by the equation p=$87.50
– 0.02(D).

a) What is the optimal volume of sprinklers? Does Acme make a

profit at that volume?
b) What is the range of profitable demand?

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 Solution
a)What is the optimal volume of sprinklers? Does Acme make a
profit at that volume?
∗
𝑎 − 𝑐𝑣 87.50 − 15.50
D = = = 1,800
2𝑏 2 0.02

b)What is the range of profitable demand?

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 Example

One company in manufacturing industry has quantified the

relationship between the price of its product and the demand
for this product as Price = 120 - 0.02×Demand. The fixed cost
(i.e., equipment acquisition) per year = $8,000 and the variable
cost per unit = $30. What is the maximum profit that can be
achieved if the maximum expected demand is 1,500 units per
year? What is the unit price at this point of optimal demand?

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 Solution

Profit = TR-30D-$8000
= (120-0.02D)*D-30D-$8000
= -0.02D^2+90D-8000

P*= -0.02*1500^2 + 90*1500 – 8000 = $82,000

The unit price @ D =1500 units should be 120-0.02*1500 = $90

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“Present economy studies” can ignore
the time value of money.
• Alternatives are being compared over one year or
less.
• When revenues and other economic benefits vary
among alternatives, choose the alternative that
maximizes overall profitability of defect-free
output.
• When revenues and other economic benefits are
not present or are constant among alternatives,
choose the alternative that minimizes total cost per
defect-free unit.

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 Example
As energy costs continue to rise, power efficiency is increasingly
important. Acme Chemical is evaluating two different electric motors to
drive a mixing motor and needs to perform a present economy study.
The motor will produce 75 hp and will be operated eight hours per day,
365 days for one year (maintenance will be performed on second shift—
assume no down time during operation), after which time the motor will
have no value. Select the most economical motor. Assume Acme’s
electric power costs $0.16 per kWh. 1 hp = 0.746 kW.

Motor A Motor B
Purchase price $3,200 $5,900
Efficiency 0.75 0.85

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 Solution
Motor A

Motor B

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• Results of cost estimating are used for a variety of
purposes, including the following:
1. Providing information used in setting a selling price for quoting,
bidding, or evaluating contracts
2. Determining whether a proposed product can be made and distributed
at a profit
3. Evaluating how much capital can be justified for process changes or
other improvements
4. Establishing benchmarks for productivity improvement programs

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Integrated cost estimation approach
Three major components:
• Work breakdown structure (WBS)
• Cost and revenue structure (classification)
• Estimating techniques (models)

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Work Breakdown Structure (WBS)
The integrated approach begins with a description of the project in
terms of a WBS. It is used to describe the project and each alternative’s
unique characteristics in terms of design, labor, material requirements,
and so on.

• It is developed from the top (project level) down in successive levels

of details.
• The project is divided into its major work elements (Level 2).
• These major elements are then divided to develop Level 3, and so
on.
• This process is continued until the desired detail in the definition
and description of the project or system is achieved.
How many levels? Typically 4 levels
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WBS for Commercial Building Project

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 Cost and Revenue Structure
• The second basic component of the integrated approach for
developing cash flows.
• Used to identify and categorize the costs and revenues that need
to be included in the analysis.
• A brief listing of some categories of costs and revenues that are
typically needed in an engineering economy study:
1. Capital investment (fixed and working)
2. Labor costs
3. Material costs
4. Maintenance costs
5. Property taxes and insurance
6. Overhead costs
7. Disposal costs
8. Revenues
9. Quality (and scrap) costs
10. Market (or salvage) values

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 Estimating Techniques
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.
1. Order-of-magnitude estimates (±30%)
2. Semi-detailed, or budget, estimates (±15%)
3. Definitive (detailed) estimates (±5%)

The level of detail and accuracy of estimates depends on the following:

1. Time and effort available as justified by the importance of the study
2. Difficulty of estimating the items in question
3. Methods or techniques employed
4. Qualifications of the estimator(s)
5. Sensitivity of study results to particular factor estimates.
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 Indexes
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.

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Indexes can be created for a single item or for
multiple items.

M = total number of items in the index (1 ≤ m ≤ M)

Cnm = unit cost (or price) of the mth item in year n
Ckm = unit cost (or price) of the mth item in year k
Wm = weight assigned to the mth item
Ik = composite index value in year k

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 Example
The prices of gasoline in 1996 and 2014 are given in the table below.
The weight placed on regular unleaded gasoline is twice that of unleaded
plus and the weight placed on unleaded plus is three times that of
premium.
Price in year
1996 2014
Premium 114 315
Unleaded plus 103 305
Reaular unleaded 93 285

a) Based on the following data, develop a weighted index for the price of
a gallon of gasoline in 2014, when 1996 is the reference year having an
index value of 103.6.
b) The index in 2016 is estimated to be 330. Determine the
corresponding 2016 prices of gasoline from I2014 .
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 Solution
315 305 285
1 + 3 + 6
114 103 93
𝐼𝑛𝑑𝑒𝑥 = ∗ 103.6 = 311.14
1+3+6

330
𝑃𝑟𝑒𝑚𝑖𝑢𝑚: $315 = $334.1
311.14
330
𝑈𝑛𝑙𝑒𝑎𝑑𝑒𝑑 𝑝𝑙𝑢𝑠: $305 = $323.5
311.14
330
𝑅𝑒𝑔𝑢𝑙𝑎𝑟 𝑢𝑛𝑙𝑒𝑎𝑑𝑒𝑑: $285 = $302.3
311.14

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 Power-Sizing Technique
The power-sizing technique is frequently used
for developing capital investment estimates
for industrial plants and equipment.

(both in $ as of the point in time

for which the estimate is desired)

(both in the same physical units)

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 Example
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?

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Solution

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 Learning Curve

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.

For example, if 100 labor hours are required to produce the first output unit and a 90%
learning curve is assumed, then 100(0.9) = 90 labor hours would be required to produce the
second unit. Similarly, 100(0.9)2 = 81 labor hours would be needed to produce the fourth
unit, 100(0.9)3 = 72.9 hours to produce the eighth unit, and so on.
Therefore, a 90% learning curve results in a 10% reduction in labor hours each time the
production quantity is doubled.

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40
 Example

Assume the first unit of production required 3 hours time for

assembly. The learning rate is 75%.

a) The time to assemble the 8th unit?

b) The time needed to assemble the first 6 units?
c) The estimated cumulative average assembly time for the
first 6 units?

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 Solution

Cx = Tx /𝑥

C6 = T6 /6 = 11.8/6 = 1.97
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 Cost Estimating Relationship (CER)

• A CER is a mathematical model that describes the cost

of an engineering project as a function of one or more
design variables.

• Formulate an equation that accurately captures the

relationship between the selected cost driver(s) and
project cost.

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There are four basic steps in developing a CER:

Step1. Problem definition: A well-defined problem is much easier to

solve. Developing a WBS is an excellent way of describing the
elements of the problem.

Step2. Data collection and normalization: Data collection and

normalization: “garbage in—garbage out.” Without reliable data, the
cost estimates obtained by using the CER would be meaningless.

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Step3. CER equation development:
✓ Determine an appropriate equation form for the CER.
A simple way to determine the equation is to plot the data.
Typical Equation Forms:

✓ Determine the values of the coefficients in the CER equation.

The coefficients b0 and b1 in the simple linear equation 𝑌 = b0 + b1 𝑋:

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Step4. Model validation and documentation
• Once the CER equation has been developed, we need to determine
how well the CER can predict cost and document the development
and appropriate use of the CER.
• Validation can be accomplished with statistical measures such as
standard error and the correlation coefficient.
The standard error (SE) is calculated by:

The correlation coefficient (R) is calculated by:

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 Example
In the early stages of design, it is believed that the cost of a Martian rover
spacecraft is related to its weight. Cost and weight data for eight spacecrafts have
been collected and normalized and are shown in the next table. A plot of the data
suggests a linear relationship.

Spacecraft i Weight (Ib) x Cost ($ million) y

1 440 270
2 550 400
3 660 550
4 700 700
5 740 750
6 830 810
7 990 890
8 1100 950

a) Estimate the b0 and b1 coefficients and develop a CER for the packaging cost.
b) If an spacecraft weighs 880 lb, estimate the cost?
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 n x y x^2 xy
1 440 270 193600 118800
2 550 400 302500 220000
3 660 550 435600 363000
4 700 700 490000 490000
5 740 750 547600 555000
6 830 810 688900 672300
7 990 890 980100 881100
8 1100 950 1210000 1045000
Total 6010 5320 4848300 4345200

8 4,345,200 − 6,010 5,320

b1 = = 1.04
8 4,848,300 − 6,010 2

5,320 − 1.04 6,010

b0 = = −120.65
8

𝑌 = 1.04𝑋 − 120.65

𝐸𝑠𝑡𝑖𝑚𝑎𝑡𝑒𝑑 𝐶𝑜𝑠𝑡 = 1.04 ∗ 880 − 120.65 = $794.55

Spreadsheet Solution?
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