Engineering Economics

Dr. Karim

Chapter 3: Engineering Costs &

Cost Estimating

Keyword: Consumer Price Index

The Consumer Price Index (CPI) is a statistical
measure of change, over time, of the prices of a
market basket of consumer products (such as
transportation, food and medical care) purchased
by households.
The CPI gives an overall image about the evolution
of prices over time in a specific country.

Engineering Costs
Evaluating a set of feasible alternatives requires
that

many

include

costs

costs

construction,

for:

be

analyzed.

initial

facility

Examples

investment,

modification,

new

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).

Types of Costs

Fixed, Variable and Total Costs

Marginal Costs & Average Costs
Sunk Costs
Incremental Costs
Opportunity Costs
Recurring & Non-recurring Costs
Cash Costs & Book Costs
Life-Cycle Costs

Fixed, Variable and Total Costs

Fixed Costs: constant, independent of the output or
activity level.
Property taxes, insurance
Management and administrative salaries
License fees, and interest costs on borrowed capital
Rental or lease
Variable Costs: Proportional to the output or activity
level.
Direct labor cost
Direct materials
Total Variable Cost = Unit Variable Cost * Quantity
Produced

Fixed, Variable and Total Costs

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

expenses as either fixed or variable:

these

Breakeven Analysis
Total Revenue = Unit Selling Price * Quantity Sold
Profit = Total Revenue - Total Cost
The break-even point(BEP) is the point at which total
cost and total revenue are equal: there is no net loss or
gain, and one has "broken even."

Applications of Breakeven analysis:

- Determining the minimum number ofunitsto be
sold in order to cover total cost
BE volume = Total Fixe Cost / [Unit Price Unit
Variable Cost]
- Forecast production profit / loss

TR

TC

FC

Breakeven Analysis
Total Revenue

$
Profit

Total Costs

Variable Costs

Fixed Costs

Loss

Break-even Point

Units of
Outputs

Applied Example
Total Revenue
= 35X

$1000
Profit
$80
0

Variable Costs
= 20X

$60
0
$40
0
$20
0
$0

Total Costs
= $225 + 20X

Fixed Costs
= $225

Loss

10

15

20

25

X
Units of Outputs

Breakeven Charts
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

Marginal Costs and Average Costs

Average Cost: total cost divided by the total number of
units produced.
Basis for normal pricing

Marginal Cost: the change in total cost (or total variable

cost) that comes from producing one additional unit in the
short run.
The purpose of analyzing marginal cost is to determine at what
point an organization can achieveeconomies of scale (Capacity
Planning). The calculation is most often used among manufacturers
as a means of isolating an optimum production level.
Basis for last-minute pricing

Capacity Planning

Sunk Costs
Sunk Costs are irreversible expenses
incurred previously. They are irrelevant
to present decisions. For example,
if you decide to have your employees
work three shifts instead of two, your
rent should stay the same.

Sunk Costs
In the 1970's Lockhead spent $ 1
billion
developing a new airplane (Tristar).
After
sinking the money, it was clear that
the venture was not going to be a
success.
Lockhead went to its creditors, and
asked

Sunk Costs
Some of the creditors said, Why put
in
more money, since there is no way we
can

Who
right?

was

Sunk Costs
Answer: Both arguments are wrong.
The billion dollar initial investment is
a sunk cost that is irrelevant to
the present decision.

We

should

extra

compare
revenue

the
of

Dont cry over spilt

milk!!

Incremental Costs
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 $17,500, the incremental initial
cost of (B - A) is $7,500.

Example

Choose between alternative models A and B.

What incremental costs occur with model B?

Costs
Model
Cost Items
Purchase price
Installation costs
Annual maintenance costs
Annual utility expenses
Disposal costs after useful life

A
$ 10,000.00
$ 3,500.00
$ 2,500.00
$ 1,200.00
$ 700.00

B
$ 17,500.00
$ 5,000.00
$ 750.00
$ 2,000.00
$ 500.00

Incremental
$ 7,500.00
$ 1,500.00
$(1,750.00)
$ 800.00
$ (200.00)

Opportunity Costs
In engineering economics, the opportunity cost concept (hidden cost) is
useful in decision involving a choice between different alternative
courses of action. Resources are scarce We cannot produce all the
commodities For the production of one commodity, we have to
forego the production of another commodity We cannot have
everything we want. We are, therefore, forced to make a choice.
Opportunity cost of a decision represents the benefits or
revenue forgone by pursuing one course of action rather than
another.
The economic significance of opportunity cost is as follows:
1. It helps in determining relative prices of different products.
2. It helps in determining normal remuneration to a factor of production.
3. It helps in proper allocation of factor resources.

Recurring Costs and Non-recurring Costs

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

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

Cash Costs & Book Costs

A cash cost requires the cash transaction of dollars
"out of one person's pocket" into "the pocket of
someone else. When you buy dinner for your friends or
make your monthly automobile payment you are
incurring a cash cost or cash flow. Cash costs and cash
flows are the basis for engineering economic analysis.
Book costs do not require the transaction of dollars
"from one pocket to another." Rather, book costs are
cost effects from past decisions that are recorded "in
the

books"

(accounting

books)

of

firm.

asset

depreciation, is a common example of book cost. Book

Life-Cycle Costs
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

requirements)

needs
and

or
ends

wants

(the

with

the

Cost Estimating
Engineering economic analysis involves present
and future economic factors; thus, it is critical
to obtain reliable estimates of future costs,
benefits and other economic parameters.
Estimating is the foundation of economic
analysis.

Types of Estimates
An engineer should ask himself How accurate do I want
my cost estimation to be ?. 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.
N.B. We must balance the needed accuracy with the cost
to perform the cost estimation.

Cost Estimating Models

Model

Explanation

Per Unit

Theper-unit modeluses a "per unit" factor,

such as cost per square meter (m2), to develop
the

estimate

desired.

This is a very simplistic yet useful technique,

especially for developing estimates of the
rough type. The per unit model is commonly
used in the construction industry.

Cost Estimating using Per-Unit Model

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

Example of Cost Estimating using Per-Unit

Model
We may be interested in a new home that
is constructed with a certain type of
material and has a specific construction
style.

Based

on

this

information

contractor may quote a cost of $65 per

square meter for our home. If we are
interested in a 2000 square meter floor
plan, our cost would thus be: 2000 x 65

Model
Segmenting

Cost Estimating Models

Explanation
Thesegmenting modelbreaks up the total
estimation task into segments (estimates are
made at component level). Each segment is
estimated, then the segment estimates are
combined for the total cost estimate.

Example of Cost Estimating using Segmenting

Model
Cost estimate of lawn
mower
A.
Chassis
Cost Item
A.1 Deck
A.2 Wheels
A.3 Axles
Subtotal

Estimate
$7.40
10.20
4.85
$22.45

B. Drive Train
Cost Item
Estimate
B.1 Engine
$38.50
B.2 Starter assembly
5.90
B.3 Transmission
5.45
B.4 Drive disc assembly
10.00
B.5 Clutch linkage
5.15
B.6 Belt assemblies
7.70
Subtotal
$72.70

Example of Cost Estimating using Segmenting

Model
Cost estimate of lawn
mower
C.
Controls
Cost Item

Estimat
e
C.1 Handle assembly
$3.85
C.2 Engine linkage
8.55
C.3 Blade linkage
4.70
C.4 Speed control linkage
21.50
C.5 Drive control assembly
6.70
C.6 Cutting height adjuster
7.40
Subtotal
$52.70

D. Cutting/Collection
system
Cost Item
Estimate
D.1 Blade assembly
D.2 Side chute
D.3 Grass bag &
adapter
Subtotal

$10.80
7.05
7.75
$25.60

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

= $173.45

Model
Cost
Indexes

Cost Estimating Models

Explanation
Cost

indexescan

be

used

to

reflect

historical

changes in costs. Cost index could be individual cost

items (labor, material, utilities), or group of costs
(Consumer Prices Index- CPI; Producer Prices Index - PPI).
Suppose (A) is a time point in the past and (B) is the
current time. Let IVAdenote the index value at time (A)
and IVB denote the current index value for the cost
estimate of interest.
CostTo estimate
Indexthe current cost based
A

on the cost at time (A), use the equation:

Cost B Index B
A

Example of Cost Estimating Using Cost Indexes

Labor Cost Now

Index now
Labor Cost 10 yrs
Index
10 yrs

188
$871,800
124

$575,500

Material Cost Now

Index now
Material Cost 3 yrs
Index
3 yrs

715
$2,455,000
$3,227,000
544

Project Cost

now

= Project Cost 5 years [CPI now /CPI

[116/103]= $ 473000

5 years

] = $420000

Cost Estimating Models (con)

Model
Explanation
Pow
Thepower-sizing
modelaccounts
explicitly
for
er
economies of scale. For example, the cost of
Sizin
constructing a six floor building will typically be less
g
than double the construction cost of a comparable
three floor building. To estimate the cost of B based on the
cost of comparable item A, we use the equation:
Cost of B = (Cost of A) [ ("Size" of B) / ("Size" of
A) ]x
Where x is the appropriate power-sizing exponent, available
from a variety of sources including industry reference
books, research reports, and technical journals. An economy
of scale is indicated by an exponent less than 1.0 An
exponent of 1.0 indicates no economy of scale, and an

Example of X = Power Sizing

Exponent
Equipment/Facility

Equipment/Facility

Blower, centrifugal

0.59

Filter, vacuum

0.48

Compressor

0.32

Lagoon, aerated

1.13

Crystallizer, vacuum

0.37

Motor

0.69

Dryer, drum

0.40

Reactor

0.56

Fan, centrifugal

1.17

Tank, horizontal

0.57

Example of Cost Estimating Using Power-Sizing

Model

Based on her work ,Miriam has been asked to estimate the cost today of a 2500 ft^2 heat exchange system for the
new plant being analyzed. She has the following data:
-

Her company paid $50,000.0for a 1000 ft^2 heat exchanger 5 years ago.
Heat exchangers within this range of capacity have a power sizing exponent (x) of .0.55 (< 1

economy of scale ).
-

Five years ago the Heat Exchanger Cost Index (HECI) was 1306; it is 1487 today.

Example of Cost Estimating Using Power-Sizing

Model
SOLUTION
Miriam will first use the power sizing equation to scale
up the cost of the 1000 ft^2 exchanger to one that is
2500 ft^2 using the 0.55 power-sizing exponent :

2500 ft
2
1000
ft

Cost 2500 ft 2 Cost1000 ft 2

2500
$50,000

1000

0.55

0.55

$82,800

Example of Cost Estimating Using Power-Sizing

Model
Miriam knows that the $82,8000 reflects only the scaling
up of the cost of the 1000 ft^2 model to a 2500 ft^2
model.
Now she will use the cost indexes equation and the HECI
data to estimate the cost of a 2500 ft^2 exchanger
today. Miriam's cost estimate would be:

Cost Estimating Models (con)

Model
Explanation
Learning The theory of the learning curve is based on the
Curve

simple idea that the time required to perform a task

decreases as a worker gains experience. The basic

concept is that the time, or cost, of performing a

task decreases at a constant rate as cumulative
output doubles. Learning curves are useful for
preparing cost estimates, bidding on special orders,
setting

labor

standards,

scheduling

labor

requirements, evaluating labor performance, and

setting incentive wage rates. In general, as output
doubles the unit production time will be reduced to

Cost Estimating Using Learning Curve Model

For example, a learning curve rate of 70% represents much faster learning than a rate of 90%. If an operator
exhibits learning on a certain task at a rate of 70%, the time required to complete production unit 50, for
example, is only 70% of the time required to complete unit 25.

Learning Curve Rates in Different Industries

1) Aerospace 85%
2) Shipbuilding 80-85%
3) Complex machine tools for new models 75-85%
4) Repetitive electronics manufacturing 90-95%
5) Repetitive machining or punch-press operations 90-

95%
6) repetitive electrical operations 75-85%
7) Repetitive welding operations 90%
8) Raw materials 93-96%
9) Purchased Parts 85-88%

Wright's Cumulative Average

Model

In Wright's Model, the learning curve function is defined as

follows:
Y = aXb
where:
Y = the cumulative average time (or cost) per unit.
X = the cumulative number of units produced.
a = time (or cost) required to produce the first unit.
b = slope of the function when plotted on log-log paper.
= Log of the learning rate in decimal form /Log 2
For an 80% learning curve b = Log .8/Log 2 = -.09691/.301 =
-.32196
If the first unit required 100 hours, the equation would be: Y =
100X-.322

Wright's Cumulative Average

Model

Cost Estimating Using Learning Curve Model

Let
T1 = Time to perform the 1st unit
TN = Time to perform the Nth unit
b = Learning curve exponent = Constant based on learning
curve rate
= log (learning curve rate in decimal form) / log 2
N = Number of completed units

log %
ln %
b

log 2
ln 2

TN T1 N

Example of Cost Estimating Using Learning Curve Model

Example of Cost Estimating Using Learning Curve

Example 2-9
Cost Estimating
Model

using Learning Curve

N
1
2
3
4
5
6
7
8
9
10

b
0.2345
TExample

(
9
.
6
)

N
2-9 Cost
N
1
Tusing
T
Estimating
N
N
N
11 Curve
5.47
9.60
Learning

8.16
7.42
6.94
6.58
6.31
6.08
5.90
5.73
5.59

12
13
14
15
16
17
18
19
20

5.36
5.26
5.17
5.09
5.00
5.00
5.00
5.00
5.00

The

learning

curve

slope

"how fast" learning occurs.

indicates

Estimating Benefits
So far we have focused on cost terms and cost estimating.
However,

engineering

economists

must

often

also

estimate benefits. 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
0
1
2
3
4
5
6

Capital costs
$ (80,000.00)

$ 10,000.00

O&M

Overhaul

$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)
$ (12,000.00)

$ (25,000.00)

Total
$ (80,000.00)
$ (12,000.00)
$ (12,000.00)
$ (37,000.00)
$ (12,000.00)
$ (12,000.00)
$ (2,000.00)

C a s h f lo w

Cash flow
$20,000.00
$$(20,000.00)
$(40,000.00)
$(60,000.00)
$(80,000.00)
$(100,000.00)

Overhaul
O&M
Capital costs

Ye ar