Engineering Economy

(0901420)

Muhammad T. Hatamleh, PhD

Department of Civil Engineering
Slides 3
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Chapter 3: Cost Estimation Techniques
Topics to be covered this week:
• Objective
• Approaches for cost estimation
• Integrated cost estimation approach
• Work breakdown structure (WBS)
• Cost and Revenue Structure
• Sources of estimating data
• Estimating techniques (models):
1. Indexes (ratio technique)
2. Unit technique
3. Factor technique
4. Parametric cost estimating
a) Power sizing technique.
b) Learning curve.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Chapter 3: Cost Estimation Techniques
Objective:

• To present various methods for estimating important factors (costs, revenue, useful
lives, residual values, etc.) in an engineering economy study.

• Cost estimation is useful for:

1) Setting up a selling price for a quote or a bid.
2) Determining if a product will be profitable.
3) Justifying capital for process changes or improvements.
4) Setting benchmarks for productivity improvements.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Cost Estimation Techniques
Two fundamental approaches for cost estimation:
 Top-down approach
• Good for early estimates when developing alternatives.
• Uses historical data from similar projects with adjustments to account for inflation,
deflation, and other factors.
 Bottom-up approach
• More detailed approach.
• Project is broken down into small units.
• The estimated overall cost is the sum of the units’ costs + other costs (e.g.
overhead).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Cost Estimation Techniques
Two fundamental approaches for cost estimation:
 Top-down approach
A simple example of cost estimating is to forecast the expense of getting a Bachelor of Science (B.S.) from the university
you are attending.
Suppose that the published cost of attending your university is $15,750 for the current year. This figure is anticipated to
increase at the rate of 6% per year and includes fulltime tuition and fees and a weekly meal plan.
Not included are the costs of books, supplies, and other personal expenses. For the initial estimate, these “other”
expenses are assumed to remain constant at $5,000 per year.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Cost Estimation Techniques
Two fundamental approaches for cost estimation:
 Bottom-up approach
The same example to forecast the expense of getting a
Bachelor of Science (B.S.) from the university you
are attending:

Break down anticipated expenses into the typical

categories for each of the four years at the university

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Integrated cost estimation approach
An integrated approach to developing the net cash flows for feasible project alternatives
have three basic components:

1. Work breakdown structure (WBS):

Successive levels of the work elements and their interrelationships.

2. Cost and revenue structure (Classification):

Projection of cost and revenue categories and elements for different WBS levels.

3. Estimating techniques (Models):

Selected mathematical models to estimate future costs and revenues.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Integrated cost estimation approach (Cont.)

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

1. Work breakdown structure (WBS)
WBS is a basic tool in Project Management.

 WBS defines all project elements and their interrelationships, collecting and organizing
information, and developing relevant cost and revenue data and management activities.
 WBS includes recurring (maintenance) and nonrecurring (initial construction) work elements.

 Each WBS level further details the work elements.

 The resources required for a work element are the sum of resources of sub-elements below it.

WBS Includes functional and physical work elements.

 Functional (logistic support, project management, and marketing).
 Physical (labor, materials, and resources required for the making of a product).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Work breakdown structure (WBS) (Cont.)

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Work breakdown structure (WBS) (Cont.)
Example: Develop the first
three levels of a representative
WBS adequate for constructing
of a small commercial building.

Level 1 is the total project.

Level 2, the project is divided
into seven major physical work
elements and three major
functional work elements.
Level 3: each of these major
elements is divided into sub
elements as required.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Work breakdown structure (WBS) (Cont.)
Important terms in the WBS:

 Level of Effort: Level of Effort (LOE) is how much work is required to complete a task.

 WBS Code: A unique identifier assigned to each element in a Work Breakdown Structure for the purpose of designating the
elements' hierarchical location within the WBS.

 Work Package: A Work Package is a deliverable or work component at the lowest level of its WBS branch.

 WBS Component: A component of a WBS which is located at any level. It can be a Work Package or a WBS Element as
there's no restriction on what a WBS Component is.

 WBS Element: A WBS Element is a single WBS component, and its associated attributes located anywhere within a WBS.
• A WBS Element contain other WBS components or Work Packages.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

2. Cost and Revenue Structure
A structure where costs and revenue that will be included in the analysis have to be:
• Identified.
• Categorized.

The most serious source of errors in developing cash flows is overlooking important
categories of costs and revenues.

The cost and revenue structure prepared by using:

• Checklist form.
• The life-cycle concept and the WBS.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Cost and Revenue Structure (Cont.)
Examples of cost and revenue categories:

• Capital investment.
• Labor costs.
• Material costs.
• Maintenance costs.
• Overhead.
• Disposal costs.
• Sales revenue.
• Market (or salvage) value.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

3. Estimating techniques (models)
The goal is to develop cash flow projections, not exact future data
(which is almost impossible).

Cost and revenue estimates can be classified to:

 Order-of-magnitude estimates

 Semi-detailed (or budget) estimates

 Definitive (detailed) estimates

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Estimating techniques (models) (Cont.)
 Order-of-magnitude estimates
• Planning and initial evaluation of a project to select feasible
alternatives (±30 – 50% accuracy).
• Level 1 or 2 of the WBS.

 Semi-detailed (or budget) estimates

• Preliminary or conceptual design stage of
a project (±15% accuracy).
• Level 2 or 3 of the WBS.

 Definitive (detailed) estimates

• Detailed design estimates from drawings, specs,
quotes, … used for bidding (±5% accuracy).
• Level 3 and beyond.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Estimating techniques (models) (Cont.)
The level of detail and accuracy of estimates should depend 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

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Estimating techniques (models) (Cont.)
Sources of estimating data
• Accounting records:
 they are often not suitable for direct, unadjusted use.

• Other sources inside the firm:

 engineering, sales, production, quality and purchasing departments.

• Sources outside the firm:

 Published information
 Personal contacts

• Research and development (R&D):

 If the information is not published and cannot be obtained
by consulting someone, the only alternative may be to
undertake R&D to generate it.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Estimating techniques (models) (Cont.)
Some of the Estimating techniques that will be covered in this course are:

1. Indexes (ratio technique)

2. Unit technique

3. Factor technique

4. Parametric cost estimating

a) Power sizing technique.
b) Learning curve.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

1.Indexes (ratio technique)
- An index is a dimensionless number used to estimate present and future costs from historical data.

𝐼𝑛ҧ
𝐶𝑛 = 𝐶𝑘 ×
𝐼𝑘ҧ

Where:
k: reference year.
n: year to be estimated at.
Cn and Ck: cost or price in years n and k, respectively.
Īn and Īk are the index values for the years n and k, respectively.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Indexes (ratio technique) Example
A company wants to install a new boiler. The price of the boiler in the year
2016 was $525,000 when the index was 468. What is the price of the boiler
in 2021 given that the index value is 542 in the year 2021?

𝐼2021
𝐶2021 = 𝐶2016 ×
𝐼2016

542
𝐶2021 = 525,000 × = $608,013
468
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
2. Unit technique

 Widely used and understood.

 Good for preliminary estimates.

Examples:
• Cost per m2 of construction × area of construction.
• Operating cost per mile × number of miles.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Unit technique Example
Suppose the Air Force’s B-2 aircraft costs $68,000 per hour to own, operate, and maintain. A certain mission
requires two B-2 aircrafts to fly a total round-trip time of 45 hours.

The total cost of this mission is

(2 planes) * (45 hours per mission per plane) * ($68,000 per hour) = $6,120,000 per mission.

While the unit technique is very useful for preliminary estimating purposes, such average values can be
misleading. In general, more detailed methods will result in greater estimation accuracy.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

3. Factor technique
 Extension of the unit technique.
 Good for preliminary estimates.

𝐶 = ෍ 𝐶𝑑 + ෍ f𝑚 𝑈𝑚
𝑑 𝑚
Where:
C = cost being estimated;
Cd = cost of the selected component d that is estimated directly;
fm = cost per unit of component m;
Um = number of units of component m.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Factor technique Example
Suppose that we need a slightly refined estimate of the cost of a house consisting of 2,000 square feet, two
porches, and a garage. Using a unit factor of $85 per square foot, $10,000 per porch, and $8,000 per garage
Calculate the total estimate:

 ($85 × 2,000) + ($10,000 × 2) + ($8,000 x 1) = $198,000.

• The factor technique is particularly useful when the complexity of the estimating situation does not
require a WBS but several different parts are involved. Check Example 3-5 in the book.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

4. Parametric Cost Estimating
• Utilizing historical cost data and statistical techniques to predict future costs.

• These models are used in early design stages to get an estimate of a product or
project cost based on few physical characteristics (e.g. weight, volume, power).

• The outputs are used to gauge the impact of design decisions on the total cost.

• Common techniques (parametric models):

Power sizing technique.
Learning curve.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Power Sizing Technique
 Referred to as the exponential model.
 Used for industrial plants and equipment.

𝐶𝐴 𝑆𝐴 𝑋 𝑆𝐴 𝑋
= or 𝐶𝐴 = 𝐶𝐵 ∗
𝐶𝐵 𝑆𝐵 𝑆𝐵

Where:
CA and CB : costs for plants A and B, respectively ($ as of the time for which the estimate is desired).
SA and SB : sizes of plants A and B, respectively (same physical units).
X: cost-capacity factor which depends on the type of plant.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Power Sizing Technique Example
The purchase price of a commercial boiler (capacity S) was $181,000 eight years ago. Another boiler of the same basic design,
except with capacity 1.42 S, is currently being considered for purchase. If the cost index was 162 for this type of equipment when
the capacity S boiler was purchased and is 221 now, and the applicable cost capacity factor is 0.8, what is your estimate of the
purchase price for the new boiler?

Let
𝐶𝐴 = cost of new boiler today with capacity of (𝑆𝐴 = 1.42 S)
𝐶𝐵 = cost of old boiler today with capacity of (𝑆𝐵 = S).
0.8
1.42𝑆
𝐶𝐴, 𝑇𝑜𝑑𝑎𝑦 = 𝐶𝐵, 𝑇𝑜𝑑𝑎𝑦 ×
𝑆

𝐼𝑇𝑜𝑑𝑎𝑦
𝐶𝐵, 𝑇𝑜𝑑𝑎𝑦 = 𝐶𝐵, 𝐸𝑖𝑔ℎ𝑡 𝑦𝑒𝑎𝑟𝑠 𝑎𝑔𝑜 ×
𝐼𝐸𝑖𝑔ℎ𝑡 𝑦𝑒𝑎𝑟𝑠 𝑎𝑔𝑜

221
𝐶𝐵 = $181,000 × = $246,920.
162
0.8
1.42𝑆
𝐶𝐴 = $246,920 × = $326,879
𝑆
Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
Power Sizing Technique Example
Suppose that an aircraft manufacturer desires to make a preliminary estimate of the cost of building a 600-MW
fossil-fuel plant for the assembly of its new long-distance aircraft. It is known that a 200-MW plant cost $100
million, 20 years ago when the approximate cost index was 400, and that cost index is now 1,200. The cost-
capacity factor for a fossil-fuel power plant is 0.79.

𝐼𝑇𝑜𝑑𝑎𝑦
𝐶𝑜𝑙𝑑 𝑝𝑙𝑎𝑛𝑡, 𝑇𝑜𝑑𝑎𝑦 = 𝐶𝐵, 20 𝑦𝑒𝑎𝑟𝑠 𝑎𝑔𝑜 ×
𝐼20 𝑦𝑒𝑎𝑟𝑠 𝑎𝑔𝑜

1200
𝐶𝐵 = $100 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × = $300 𝑚𝑖𝑙𝑙𝑖𝑜𝑛.
400

0.79
600 𝑀𝑊
𝐶𝐴 = $300 𝑚𝑖𝑙𝑙𝑖𝑜𝑛 × = $714 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
200 𝑀𝑊

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Learning curve
 Also called experience curve or manufacturing progress function.
 Reflects increased efficiency and performance with repetitive production.

𝑍𝑢 = 𝐾(𝑢𝑛 )
Where:
u = the output unit number;
Zu = the number of input resource units needed to produce output unit u;
K = the number of input resource units needed to produce the first output unit;
n = learning curve exponent = log 𝑠 / log 2
s = the learning curve slope parameter expressed as a decimal (s = 0.9 for a 90% learning curve).

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Learning curve Example
The time required to assemble the first car is 100 hours and the learning rate is 80%. What is the time
required to assemble the 10th car?

𝑆 = 0.8, 𝐾 = 100 hours, 𝑢 = 10 cars

log 0.8
𝑍10 = 100 × 10 log 2 = 47.65 hours

*** This is not the total time to produce 10 units … it’s the time to produce the 10th unit ***

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Learning curve Example

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

Example
You have been asked to estimate the cost of 100 prefabricated structures, each structure provides 1,000
sq.ft of floor space, with 8-ft ceilings. In 2003, you produced 70 similar structures consisting of the same
materials and having the same ceiling height, but each provided only 800 sq.ft of floor space. The material
cost for each structure was $25,000 in 2003, and the cost capacity factor is 0.65. The cost index values for
2003 and 2014 are 200 and 289, respectively. The estimated manufacturing cost for the first 1,000 sq.ft
structure is $12,000. Assume a learning curve of 88% and use the cost of the 50th structure as your standard
time for estimating manufacturing cost. Estimate the total material cost and the total manufacturing cost
for the 100 prefabricated structures.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)

• Material cost
𝐼2003 = 200 𝐼2014 = 289
𝑆2003 = 800 𝑆2014 = 1000 𝑋 = 0.65
𝐶2003 = $25,000

𝟎.𝟔𝟓
289 1000
𝐶2014 = $25,000 × × = $41,764
200 800

• Manufacturing cost
𝑠 = 0.88 𝐾 = $12,000

log 0.88
𝑍50 = $12,000 × 50 log 2 = $5,832/unit

• Total cost = ($41,764+$5,832)×100 = $4,759,600.

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)
 The End

Muhammad T. Hatamleh, Extracted from Sullivan et al. (2018)