Various Engineering Costs

Cost Estimating and Estimating

Models

HU501/ B.Tech./ Prof. Aditi Ghosh

 Understand various cost concepts

Understand Basic Estimation Models

HU501/ B.Tech./ Prof. Aditi Ghosh

  Fixed Costs & Variable Costs
 Recurring & Non-recurring Costs
 Direct and Indirect Costs
 Cash Costs & Book Costs
 Sunk Costs & Opportunity Costs
 Marginal Costs & Average Costs
 Incremental Costs
 Life-Cycle Costs

HU501/ B.Tech./ Prof. Aditi Ghosh

  Variable Costs: Proportional to the output
or activity level ~ (also known as Prime
Cost)
• Direct labor cost
• Direct materials
• Direct Expenses

HU501/ B.Tech./ Prof. Aditi Ghosh

 O

HU501/ B.Tech./ Prof. Aditi Ghosh

  Fixed Costs / Overheads : constant,
independent of the output or activity level ~
aggregate of Indirect Labor, Indirect
Material and Indirect Expenses
• Factory overheads
• Administration overheads (Property taxes, insurance,
Management and administrative salaries, License
fees, and interest costs on borrowed capital, Rental
or lease)
• Sales cost
• Distribution Cost

HU501/ B.Tech./ Prof. Aditi Ghosh

 P

O Q1 Q2

HU501/ B.Tech./ Prof. Aditi Ghosh

HU501/ B.Tech./ Prof. Aditi Ghosh
 Elements of Cost

Material Labour Other Expenses

Direct Indirect Direct Indirect Indirect

Overheads

Production or Administrative Selling Distribution

Works Overheads Overheads Overheads Overheads

HU501/ B.Tech./ Prof. Aditi Ghosh

  Direct Costs: Costs that can be allocated to a
specific product or activity
• Direct labor
• Direct Materials

 Indirect Costs: Costs that are difficult to be

allocated to a specific product or activity
• Indirect labor
• Indirect materials

 Overhead:
• Utility
• Property tax, repair, and maintenance

HU501/ B.Tech./ Prof. Aditi Ghosh

  Standard Costs: Costs per unit of output
at a certain level of production

HU501/ B.Tech./ Prof. Aditi Ghosh

  Direct Labor: Cost of all “hands-on”
effort required to manufacture a specific
product.
- Machining
- Assembly
- Electronic and mechanical testing
- Trouble-shooting

Direct  Direct Materials: Cost of all

Materials
components and raw materials included
Direct
Labor
in the end product
  Factory Expenses:
- Indirect labor
-Material handling
-Shop supervision
-Cost estimation
-Scheduling

- Indirect materials
Factory -Material for production tooling
Expenses -Testing equipment & supplies
Direct -Packaging materials
Materials Prime - Rent
Direct Cost - Electrical utilities, heat, water & sewer
Labor - Tools and expendable factory supplies
 • General Expenses:
- Design engineering
- Purchasing
- Office salaries and
General
Expenses supplies
Factory
- Depreciation
Expenses Factory
Direct Cost
Materials Prime
Direct Cost
Labor
 • Sales Expenses:
- Advertising
Sales
Expenses
- Bad debt expense
- Shipping cost
General
Expenses Manuf.
- Salespersons’
Cost salaries
Factory
Expenses Factory
- Commissions
Direct Cost
Materials Prime
Direct Cost
Labor
 Profit
Selling
Sales Price
Expenses Total
Cost
General
Expenses Manuf.
Factory Cost
Expenses Factory
Direct Cost
Materials Prime
Direct Cost
Labor
 Ascertain the prime cost, factory cost, cost
of production and total cost and profit from
the following:
 Direct material = ` 7000
 Direct Labor = ` 2800
 Factory Expenses = ` 2600
 Administrative expenses = ` 1000
 Sales Expenses = ` 900
 Sales = ` 20000
HU501/ B.Tech./ Prof. Aditi Ghosh
  Marginal Costs: the variable cost for one
more unit of output
• Capacity Planning: Excess capacity
• Basis for last-minute pricing

 Cost of producing 20 units is `10000, cost

of producing 21units is `10050, then
marginal cost of producing 21st unit is `50

HU501/ B.Tech./ Prof. Aditi Ghosh

HU501/ B.Tech./ Prof. Aditi Ghosh
  Marginal revenue : It is the incremental
revenue from selling an additional unit of
that product.

 The revenue of selling 20 units of a

product is ` 15000, and the revenue from
selling 21 units is ` 15100, then the
marginal revenue from selling the 21st
unit is `100
HU501/ B.Tech./ Prof. Aditi Ghosh
  Average Costs: total cost divided by the
total number of units produced.
• Basis for normal pricing

HU501/ B.Tech./ Prof. Aditi Ghosh

  Recurring Costs: Repetitive and occur when
a firm produces similar goods and services on
a continuing basis
• Office space rental

 Non-recurring Costs: Not repetitive, even

though the total expenditure may be
cumulative over a period of time
• Typically involve developing or establishing a
capability or capacity to operate
• Examples are purchase cost for real estate, and the
construction costs of the plant
HU501/ B.Tech./ Prof. Aditi Ghosh
 Cash Costs: Costs that involve
money/cash transaction
• Interest payments, taxes, etc.

Book Costs: Costs that that do not

involve money/cash transaction
• Depreciation is charged for the use of
assets, such as plant and equipment

HU501/ B.Tech./ Prof. Aditi Ghosh

  Sunk Costs: Cost that has occurred in the
past and has no relevance to estimates of
future costs and revenues related to an
alternative
• Purchasing price of current equipment in
deciding new equipment (except for capital
gain/loss consideration)

 An equipment is purchased for `100000 three yrs ago. If it is

considered for replacement today, the cost will not be `
100000. Present value has to be considered for analysis. So,
purchase value of equipment from past is the Sunk Cost.

HU501/ B.Tech./ Prof. Aditi Ghosh

 Opportunity Costs:
Cost of the
foregone opportunity and is hidden or
implied
• Existing equipment in replacement analysis

 A person invests ` 50000 in shares and it will yield an

annual return of ` 7500. If the same ` 50000 was kept in a
bank FD returning 18%, then return per year would be
` 9000 i.e. ` 1500 more than current option. So, ` 1500 which
is forgone by not investing in bank is the Opportunity Cost

HU501/ B.Tech./ Prof. Aditi Ghosh

 • Purchase Price of Old Pumps $7,000 (Sunk)
• Storage Costs of Old Pumps $1,000 (Sunk)
• List Price of Old Pumps (3yrs) $9,500 (Irrelevant)
• List Price of New Pumps $12,000 (Irrelevant)
• Offer of Old Pumps (2 yrs ago) $5,000 (Irrelevant)
• Current Price of Old Pumps $3,000

HU501/ B.Tech./ Prof. Aditi Ghosh

 Incremental Costs: Difference in
costs between two alternatives.
• Suppose that A and B are mutually exclusive
alternatives. If A has an initial cost of `10,000
while B has an initial cost of ` 14,000, the
incremental initial cost of (B - A) is ` 4,000.

HU501/ B.Tech./ Prof. Aditi Ghosh

 Incremental
Cost Items Model A Model B
Cost
Purchase Price `10,000 `17,500 `7,500

Installation Costs `3,500 `5,000 `1,500

Annual Maintenance `2,500 `750 - `1,750

Annual Utility `1,200 `2,000 `800

Disposal Cost `700 `500 - ` 200

  Life-Cycle Costs: Summation of all costs,
both recurring and nonrecurring, related
to a product, structure, system, or service
during its life span.
 Life cycle begins with the identification
of the economic needs or wants (the
requirements) and ends with the
retirement and disposal activities.

HU501/ B.Tech./ Prof. Aditi Ghosh

HU501/ B.Tech./ Prof. Aditi Ghosh
 1. Need 2.Conceptual 3. Detailed 4. Production 5.Operational 6. Decline/
Assessment Design Design /Construction /Use Retirement

Requirements Impact Allocation of Production of Distribution of Phase Out

Analysis Analysis Resources Goods/ Goods/
Services Services
Overall Proof of Detailed Building of Maintenance/ Disposal
Feasibility Concept Specifications Supporting Support
Study Facilities
Conceptual Prototype/ Component/ Quality Retirement
Design Breadboard Supplier Control/ Planning
Planning Selection Assurance
Development/ Production Operational
Testing Planning Planning
Detailed
Design
Planning
 100%
90%
80%
70%
Total Life Cycle Cost

Life-Cycle Costs Committed

60%
50%
40% Life-Cycle Costs Spent

30%
20%
10%
0%
Need Conceptual Detailed Production Operational Decline/
Assessment Design Design /Construction /Use Retirement

Project Phase
 100%
90%
Ease of Design Changes
80%
Ease or cost of change

70%
60%
Cost of Design Changes
50%
40%
30%
20%
10%
0%
Need Conceptual Detailed Production Operational Decline/
Assessment Design Design /Construction /Use Retirement

Project Phase
 Needs for Cost Estimating
 Importance of 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.

HU501/ B.Tech./ Prof. Aditi Ghosh

  Rough: gut level, inaccurate
• -30% to +60%.
 Semi-detailed: based on historical
records, reasonably sophisticated and
accurate
• -15% to +20%.
 Detailed: based on detailed specifications
and cost models, very accurate
• -3% to +5%.

HU501/ B.Tech./ Prof. Aditi Ghosh

  Rough: gut level, inaccurate
• -30% to +60%.
 Semi-detailed: based on historical
records, reasonably sophisticated and
accurate
• -15% to +20%.
 Detailed: based on detailed specifications
and cost models, very accurate
• -3% to +5%.

HU501/ B.Tech./ Prof. Aditi Ghosh

 One-of-a-Kind Estimates
• Estimated parameters can be for
one-of-a-kind or first-run projects.
The first time something is done, it is
difficult to estimate costs required to
design, produce and maintain a
product over its life cycle
• “Estimation by analogy” may be used.

HU501/ B.Tech./ Prof. Aditi Ghosh

 Time and Effort Available
• Our ability to develop engineering
estimates is constrained by time and
person-power availability
• Use of limited resources in fixed
intervals of time.

HU501/ B.Tech./ Prof. Aditi Ghosh

HU501/ B.Tech./ Prof. Aditi Ghosh
 Estimator Expertise

Consider two common expressions :

“The past is out greatest teacher”
&
“Knowledge is power”

HU501/ B.Tech./ Prof. Aditi Ghosh

 Estimator Expertise : The more
experienced the estimator is
• The less difficult the estimation process
will be
• The more accurate the estimate will be
• The less likely that a major error will
occur
• More likely that estimate will be of high
quality
HU501/ B.Tech./ Prof. Aditi Ghosh
  Capital Investment (S&H, Installation, Training)
 Labor Costs (Direct and Indirect)
 Material Costs (Direct & Indirect)
 Maintenance Costs (Regular & Overhaul)
 Property Taxes and Insurance
 Operating Costs (Rental, Gas, Electricity)
 Quality Costs (Scrap, Rework, Inspection)
 Overhead Costs (Administration, Sales)
 Disposal Costs
 Revenues
 Market Values

HU501/ B.Tech./ Prof. Aditi Ghosh

  Per-UnitModel (Unit Technique)
 Segmenting Model
 Cost Indexes
 Power-Sizing Model
 Triangulation
 Improvement and the Learning Curve

HU501/ B.Tech./ Prof. Aditi Ghosh

 Per-Unit Model (Unit Technique)
• Construction cost per square foot (building)
• Capital cost of power plant per kW of
capacity
• Revenue / Maintenance Cost per mile (hwy)
• Utility cost per square foot of floor space
• Fuel cost per kWh generated
• Revenue per customer served

HU501/ B.Tech./ Prof. Aditi Ghosh

 2-4 Cost Estimating using Per-Unit Model

Cost estimation of camping on an island for 24

students over 10 days.

Planned Activities:
 2 days of boating
 3-day hikes
 3 days at the beach
 Nightly entertainment

HU501/ B.Tech./ Prof. Aditi Ghosh

 Example 2-3
Cost Estimating using Per-Unit Model
Cost Data:
• Van (capacity 15) rental: `500 one way
• Camp is 50 kms away, van gives 10kms/ litre, and fuel is
`50/ litre
• Each cabin holds 4 campers, rent is ` 50/day-cabin
• Meals are ` 50/day-camper
• Boat transportation is ` 20/camper (one way)
• Insurance/grounds fees/overhead is ` 10/day-camper
• Boat (capacity 3) rentals are ` 50/day – boat
• Day hikes are ` 50/camper-day
• Beach rental is ` 20/group-(half-day)
• Nightly entertainment is free

HU501/ B.Tech./ Prof. Aditi Ghosh

 Example 2-4
Cost Estimating using Per-Unit Model
Solution:
• Assumption: 100% participation in all activities
• Transportation Costs:
– Van: ` 500/van-trip * 2 vans * 2 trips = ` 2000
– Gas: ` 50/litre * (50 kms / 10 kms/litre) *2 *2 = ` 1000
– Boat: ` 20/camper-trip * 24 campers * 2 = ` 960
– Subtotal ` 3960
• Living Costs:
– Meals: ` 50/day-camper * 24 campers * 10 days = ` 12000
– Cabin rental: ` 50/day-cabin * (24/4) cabins *10 days = ` 3000
– Insurance: ` 10/day-camper * 24 campers * 10 days = ` 2400
– Subtotal ` 17400

HU501/ B.Tech./ Prof. Aditi Ghosh

Solution (Continued):
• Entertainment Costs:
– Boat rental: ` 50/day-canoe * 2 days * (24/3) canoes = ` 800
– Beach rental: ` 20/group-(half-day) * (3*2) half-days = ` 120
– Day hike: ` 50/camper-day* 24 campers * 3 days = ` 3600
– Nightly entertainment 0
– Subtotal ` 4520
• Total Costs: ` 25880

HU501/ B.Tech./ Prof. Aditi Ghosh

 Described as “Divide and Conquer”
 Estimate is decomposed into individual
components
 Estimates are made at component level
 Individual estimates are aggregated back
together

** The scheme of decomposing cost items is

called Work breakdown structure

HU501/ B.Tech./ Prof. Aditi Ghosh

Cost estimate of lawn mower

A. Chassis B. Drive Train

Cost Item Estimate Cost Item Estimate
A.1 Deck $7.40 B.1 Engine $38.50
A.2 Wheels 10.20 B.2 Starter assembly 5.90
A.3 Axles 4.85 B.3 Transmission 5.45
Subtotal $22.45 B.4 Drive disc assembly 10.00
B.5 Clutch linkage 5.15
B.6 Belt assemblies 7.70
Subtotal $72.70

HU501/ B.Tech./ Prof. Aditi Ghosh

Cost estimate of lawn mower
C. Controls D. Cutting/Collection system

Cost Item Estimate Cost Item Estimate

C.1 Handle assembly $3.85 D.1 Blade assembly $10.80
C.2 Engine linkage 8.55 D.2 Side chute 7.05
C.3 Blade linkage 4.70 D.3 Grass bag & 7.75
C.4 Speed control linkage 21.50 adapter
C.5 Drive control assembly 6.70 Subtotal $25.60
C.6 Cutting height adjuster 7.40
Subtotal $52.70

Total material cost = $22.45 + $72.70 + $52.70 + $25.60 = $173.45

HU501/ B.Tech./ Prof. Aditi Ghosh

  Cost indices reflect historical change in cost
 Cost index could be individual cost items
(labor, material, utilities), or group of costs
(consumer prices, producer prices)
 Indices can be used to update historical costs

Cost A Index A

Cost B IndexB

HU501/ B.Tech./ Prof. Aditi Ghosh

  Miriam is interested in estimating the annual
labour and material costs for a new production
facility. She was able to obtain the following cost
data :
• Labour costs
Labour cost index value was at 124 ten yrs ago and is 188
today
Annual labour cost for a similar facility was $575,500 ten
yrs ago
• Material costs
Material cost index value was at 544 ten yrs ago and is
715 today
Annual material costs for a similar facility was $2,455,000
ten yrs ago

HU501/ B.Tech./ Prof. Aditi Ghosh

  Index now 
Labor Cost Now  Labor Cost10 yrs  
 Index 
 10 yrs 
 188 
 $575,500   $871,800
 124 

 Index now 
Material Cost Now  Material Cost 3 yrs  
 Index 
 3 yrs 

 715 
 $2,455,000   $3,227,000
 544 
HU501/ B.Tech./ Prof. Aditi Ghosh
 The power – sizing model is used to
estimate the costs of industrial plant and
equipment.
 The model “scales up” and “scales down”
known costs
 Thus, accounting for “Economies of
Scale”
Consider the cost to build a new
plant….
Would it cost twice as much to build
the same facility with double the
capacity ?
…..Its Unlikely !!!!
 The power–sizing model uses the
exponent (x), called the power-sizing
component, to reflect economies of scale
in the size or capacity
X
 Size A 
Cost A  Cost B  
 SizeB 
(X = Power-sizing exponent, and cost of A
and B are at the same point in time)
  Miriam has been asked to estimate the
cost of a 2500 sq. ft. heat exchange system
for the new plant in the previous example.
She has the following data :
• Her company paid $ 50,000 for a 1000 sq. ft. heat
exchanger 5 years ago
• Heat exchangers within this range of capacity have
a power-sizing exponent (x) of 0.55
• Five years ago the Heat Exchanger Cost Index
(HECI) was 1306; today it is 1487.

HU501/ B.Tech./ Prof. Aditi Ghosh

Miriam will first scale up the cost of 1000 sq. ft. to 2500 sq. ft. using
0.55 power –sizing component :
A. Considering Power-Sizing Index Change
0.55
 2500 ft 2

Cost 2500 ft 2  Cost1000 ft 2  2

 1000 ft 
0.55
 2500 
 $50,000   $82,800
 1000 
Miriam knows $82,800 reflects only scalling up of 1000sq. Ft to 2500
sq ft, so she will then use the HCEI data to estimate the cost today:

B. Considering Cost Index Change

 Index now 
Cost Now  Cost 5 yrs  
 Index 
 5 yrs 

 1487 
 $82,800   $94,300
 1306 
 Techniques Used in Surveying: To map
points of interest by using three fixed
points and horizontal angular distance
 Application in Economic Analysis: To
approach economic estimate from
different perspectives, such as different
source of data, or different quantitative
models.
 Learning Phenomenon: As the number of
repetitions increase, performance of people
becomes faster and more accurate.
 Learning curve captures the relationship
between task performance and task repetition.
 In general, as output doubles the unit production
time will be reduced to some fixed percentage,
the learning curve percentage or learning
curve rate
 For example :
It may take 300 minutes to produce the 3rd unit in
a production run involving a task with a 95%
learning time curve.
In this case, the 6th unit doubles the output, so it
will take 300 (0.95) = 285 minutes to produce.

Sometimes, it is also known as Progress Curve,

Improvement Curve, Experience curve or
Manufacturing Progress Function
Learning Curve
Let T1 = Time to perform the 1st unit
TN = Time to perform the Nth unit
b = Constant based on learning curve %
N = Number of completed units

TN  T1  N b (Eq. 2-4)

log % ln %
b  (Eq. 2-5)
log 2 ln 2
 Calculate the time required to produce the
100th unitof a production run, if the 1st unit
took 32 minutes to produce and the learning
curve rate for production is 80%

T100 = T1 X 100b
=> T100 = T1 X 100 log 0.80/ log 2.0
=> T100 = 32 X 100 –0.3219
=> T100 = 7.27 minutes
N TN N TN 12.00
1 9.60 11 5.47
10.00
2 8.16 12 5.36
8.00
3 7.42 13 5.26
4 6.94

TN
14 5.17 6.00

5 6.58 15 5.09 4.00

6 6.31 16 5.00
2.00
7 6.08 17 5.00
8 5.90 18 5.00 0.00
1 3 5 7 9 11 13 15 17 19
9 5.73 19 5.00 N
10 5.59 20 5.00
 0.2345
TN  T1  N  (9.6)  N
b

10.00

8.00

6.00
10.00

4.00

2.00

0.00
1.00
1 3 5 7 9 11 13 15 17 19 1 10 100

Normal Scale Log-Log Scale

 Model Explanation
Per Unit Uses a “per unit” factor
`/sq ft, Benefits/employee
Segmenting Divide problem into items, estimate each &
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

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.