Lecture 2.

Costs Estimation Models & Cash flow

Diagram

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 Learning Objectives
 Understand various cost estimation models

 Be able to estimate engineering costs with various

models

 Cash Flow Diagrams

Copyright Oxford University Press 2009 2

 Cost Estimation
Cost estimation is the art of assigning value. It is also a
science making use of a wide range of techniques to
predict the costs of activities and assets. There exist a
wide range of methods, applications and names for
estimates.

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 Cost Estimation
 Cost Estimation is the foundation of engineering economic
analysis.

 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.

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 Significance of Cost Estimating
 Important for economic analysis

 Predicts quantity, cost & price of resources required for a

project

 Helps decision makers:-

 Profitability analysis
 Choosing between alternatives
 Make investment decisions
 Resource Allocation
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 Types of Cost Estimates
 Types of Cost Estimating

 Rough Estimates -30% to +60%

 Based on gut feelings, no -low cost, mostly inaccurate
 Used for general feasibility activities

 Semi-detailed Estimates -15% to +20%

 Based on historical records, reasonably sophisticated & accurate
 Budgeting and preliminary design decisions (low - medium cost)

 Detailed Estimates -3% to +5%

 Based on detailed specifications & cost models, very accurate
 Establishing design details and contracts (high cost)
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Trade-off between Accuracy and Cost
High
Cost of Estimate

Low
Low Medium High
Accuracy of Estimate

Figure 2-6. Accuracy versus cost trade-off in estimation

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 Difficulties in Estimation
 One-of-a-Kind or first-run projects Estimates
 Ex: First NASA mission

 Time and Effort Available

 Constraint on time and person-power can make the overall
estimating task more difficult.

 Estimator Expertise

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Categories of Cost Estimating
 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
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 Sources of Cost Estimating Data
 Accounting records
 Other sources within the firm:
 Engineering, Production, Quality
 Sales, Purchasing, Personnel
 Published information:
 Statistical Abstract of a country – Cost indexes
 Monthly Labor Review – Labor costs
 Building Construction Cost Data
 Other sources outside the firm:
 Vendor, Salespeople
 Research & Development
 Pilot plant, Test market
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 Cost Estimating Approaches
 Top-Down Approach
 Uses Historical data from similar engineering projects
 Modifies original data for changes in inflation, activity level, weight,
energy consumption, size etc.
 Best use is early in estimating process

• Bottom-Up Approach
 More detailed cost-estimating methods
 Attempts to break down projects into small, manageable units and
estimate cost, etc.
 Smaller unit costs added together with other costs to obtain overall
estimate
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 Estimating models
 Per-Unit Model (Unit Technique)

 Segmenting Model

 Cost Indexes

 Power-Sizing Model

 Triangulation

 Improvement and the Learning Curve

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.
 Estimating Models
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 historical
changes in cost.
Power Sizing Scaling previous known costs up
or down (economies of scale).
Triangulation Looking at costs from several
perspectives.
Learning Tracking cost improvements.
Curve
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Per-Unit Model (Unit Technique)
 Very simplistic model, cost /unit
 For rough orders of magnitude type
 Commonly used in construction industry

 Examples: :-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
 Revenue per customer served
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Example 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 canoeing
 3-day hikes
 3 days at the beach
 2 days for rest .

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Example 2-4:
Cost Estimating using Per-Unit
Model
Exercise: Find total cost / camper using the following data:

Cost Data:
• Van (capacity 15) rental: $50 one way
• Camp is 50 miles away, van gets 10 miles/gallon, and gas is
$1/gallon
• Each cabin holds 4 campers, rent is $10/day-cabin
• Meals are $10/day-camper
• Boat transportation is $2/camper (one way)
• Insurance/grounds fees/overhead is $1/day-camper
• Canoe (capacity 3) rentals are $5/day-canoe
• Day hikes are $2.50/camper-day
• Beach rental is $25/group-(half-day) 16
Example 2-4:
Cost Estimating using Per-Unit
Model`
Solution:

• Assumption: 100% participation in all activities

• Transportation Costs:
– Van: $50/van-trip * 2 vans * 2 trips = $200
– Gas: $1/gallon * (50 miles / 10 miles/gallon) *2 *2 = 20
– Boat: $2/camper-trip * 24 campers * 2 = 96
– Subtotal $316

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Example 2-4:
Cost Estimating using Per-Unit
Model`
Solution:

• Living Costs:
– Meals: $10/day-camper * 24 campers * 10 days = $2400
– Cabin rental: $10/day-cabin * (24/4) cabins *10 days =600
– Insurance: $1/day-camper * 24 campers * 10 days = 240
– Subtotal $3240

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Example 2-4:
Cost Estimating using Per-Unit
Model
Solution (Continued):
• Entertainment Costs:
– Canoe rental: $5/day-canoe * 2 days * (24/3) canoes = $80
– Beach rental: $25/group-(half-day) * (3*2) half-days =150
– Day hike: $2.50/camper-day* 24 campers * 3 days = 180
– Subtotal $410
• Total Costs: $3966

Thus, the total cost per student would be

$3966/24 = $165.25
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 Segmenting Model
 Estimate is decomposed into individual components
 Estimates are made at component level
 Individual estimates are aggregated back together
 Commonly used in machines, events, etc.
 Example “A lawnmower”
 Chassis
 Drive Train
 Controls
 Cutting/Collection system

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 Segmenting Model (example)

A. Chassis B. Drive Train

Cost Item Estimate Cost Item Estimate
A.1 Deck $7.00 B.1 Engine $38.50
A.2 Wheels 10.00 B.2 Starter assembly 6.90
A.3 Axles 5.85 B.3 Transmission 4.45
Subtotal $22.85 B.4 Drive disc assembly 10.00
B.5 Clutch linkage 6.15
B.6 Belt assemblies 8.70
Subtotal $72.70

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 Segmenting Model (example)
C. Controls D. Cutting/Collection system
Cost Item Estimate Cost Item Estimate
C.1 Handle assembly $2.85 D.1 Blade assembly $11.80
C.2 Engine linkage 9.55 D.2 Side chute 6.05
C.3 Blade linkage 5.70 D.3 Grass bag & 7.75
C.4 Speed control linkage 20.50 adapter
C.5 Drive control assembly 7.70 Subtotal $25.60
C.6 Cutting height adjuster 6.40
Subtotal $52.70

Total material cost = $22.85 + $72.70 + $52.70 + $25.60 = $173.85

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 Costs indexes
 Allows you to move costs between time periods therefore
it reflect historical change in cost. Also reflect relative
price changes. (Dimensionless)
 Cost index could be individual cost items (labor, material,
utilities), or group of costs (consumer prices, producer
prices)
 Indexes can be used to update historical costs
(Eq. 2-2)
CostAtTime A IndexValueAtTime A

CostAtTimeB IndexValueAtTimeB
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 Example 2.6
Alice is interested in estimating the annual labor and material costs for a
new production facility.
She was able to obtain the following labor and material cost data:
• Labor cost index value was at 124 ten years ago and is 188 today.
• Annual labor costs for a similar facility were $575,500 ten years
ago.
 Indexnow 
Labor Cost Now  Labor Cost10 yrs  
 Index 
 10 yrs 
 ___
188 
$575,500 
 _______  ___  871,800
 124 

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Example 2.6 (Continued)
Alice is interested in estimating the annual labor and material costs
for a new production facility.
She was able to obtain the following labor and material cost data:
• Material cost index value was at 544 three years ago and is
715 today.
• Annual material costs for a similar facility were $2,455,000
three years ago.

 Indexnow 
Material Cost Now  Material Cost3 yrs  
 Index
 3 yrs 
 715 
 $2, 455, 000    $3, 227, 000
 544 
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 Power-Sizing Model
• It is used to estimate the cost of industrial plants and
equipment

• It scales up or down known costs

• Not a linear model

• There is a power sizing exponent whose value is usually than 1

• Values are found in industry reference books.

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 Power-Sizing Model
X
 Size(Capacity ) A 
Cost A  Cost B  
 Size (Capacity ) B  (Eq. 2-3)
X = Power-sizing exponent
Example Power Sizing Exponent Values

Equipment/Facility X Equipment/Facility X
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
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 Example 2.7
Alice has been asked to estimate the cost today of a 2500 ft2
heat exchange system for the new plant being analyzed. She
has the following data.
• Her company paid $50.000 for a 1000 ft2 heat exchanger 5
years ago.
• Heat exchangers within this range of capacity have a
power sizing exponent (x) of 0.55
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 
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 Example 2.7 (Continued)
Alice has been asked to estimate the cost today of a 2500 ft2
heat exchange system for the new plant being analyzed. She
has the following data.
• Five years ago the Heat Exchanger Cost Index (HECI) was
1306; it is 1487 today.

B. Considering Cost Index Change

 Indexnow 
Cost Now  Cost5 yrs 
 Index 
 5 yrs 

 1487   $94,300
 $82,800  
 1306 

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 Improvement and Learning
Curve
 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
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 Learning Curve
Let T1 = Time to perform the 1st unit
TN = Time to perform the Nth unit
b = Constant based on learning curve LC%
N = Number of completed units

TN  T1  Nb (Eq. 2-4)

log LC ln LC
b  (Eq. 2-5)
log 2 ln 2

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Example 2.8
Calculate the time required to produce the hundredth unit of
a production run if the first unit took
32.0 minutes to produce and the learning curve rate for
production is 80%.

ln % ln(0.8)
b   0.3219
ln 2 ln 2

TN  T1  N b

T100  T1  (100)  (32.0)(100) 0.3219  7.27

b

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 Estimating Benefits-1
 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.
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 Estimating Benefits-2
 Cost concepts and cost estimating models can also be
applied to economic benefits

 Uncertainty in benefit estimating is typically asymmetric,

with a broader limit for negative outcomes, e.g. -50% to
+20%

 Benefits are more difficult to estimate than costs

 Benefits are usually over estimated than under estimated

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 Cash Flow Diagrams (CFD)
 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.

 Cash flow is the sum of money recorded as receipts or

disbursements in a project’s financial records.

 A cash flow diagram presents the flow of cash as arrows on a time

line scaled to the magnitude of the cash flow, where expenses are
down arrows and receipts are up arrows.

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 Drawing a Cash Flow Diagram
 In a cash flow diagram (CFD) the end of period t is the same as the
beginning of period (t+1)
 Beginning of period cash flows are: rent, lease, and insurance
payments
 End-of-period cash flows are: O&M, salvages, revenues, overhauls
 The choice of time 0 is arbitrary. It can be when a project is analyzed,
when funding is approved, or when construction begins
 One person’s cash outflow (represented as a negative value) is
another person’s inflow (represented as a positive value)
 It is better to show two or more cash flows occurring in the same
year individually so that there is a clear connection from the problem
statement to each cash flow in the diagram
 Categories of Cash Flows
 First cost: expenses to build or to buy and install

 Operations and maintenance (O&M): annual expense, such as

electricity, labor, and minor repairs

 Salvage value: receipt at project termination for sale or transfer of

the equipment

 Revenues: annual receipts due to sale of products or services

 Overhaul: major capital expenditure that occurs during the asset’s

life
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 Cash Flow Diagrams (CFD)
Example 150

100
Timing of Cash Flow Size of Cash Flow
50
At time zero (now) Positive $100 0
Series2
1 time period from today Negative $100
-50
0 1 2 3 4 5

2 time periods from today Positive $100

-100

3 time periods from today Negative $150

-150

-200
4 time periods from today Negative $150
5 time periods from today Positive $50

0 1 2 3 4 5

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 Cash Flow Example:
 Example 1: (FEIM): A mechanical device will cost $20,000
when purchased. Maintenance will cost $1000 per year.
The device will generate revenues of $5000 per year for 5
years. The salvage value is $7000.
 Example 2
 A man borrowed $1,000 from a bank at 8% interest. Two end-
of-year payments: at the end of the first year, he will repay half
of the $1000 principal plus the interest that is due. At the end
of the second year, he will repay the remaining half plus the
interest for the second year.
Cash flow for this problem is:
 End of year Cash flow
 0 +$1000
 1 -$580 (-$500 - $80)
 2 -$540 (-$500 - $40)
 Drawing Cash Flow Diagrams
with Spreadsheet
Capital 0 1 2 3 4 5 6
$20,000
Year Costs O&M Overhaul
$10,000
$-
0 -$80,000 $(10,000)

Cash Flows
$(20,000)
1 $(12,000)
$(30,000)
2 $(12,000) $(40,000)
$(50,000)
3 $(12,000) $(25,000) $(60,000)
$(70,000)
4 $(12,000) $(80,000)
5 $(12,000) $(90,000)
Year
6 $ 10,000 $(12,000)
Capital Costs O&M Overhaul

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 Think – Pair – Share

Tech Engineering Inc. makes a consumer product for which

the following cost data are available.
 Fixed cost/ year = $120,000
 Variable costs/ unit = $15
i. Determine the breakeven volume if each unit can be sold
for $40.
ii. If a net profit of $100,000 is required, determine the
number of units that needed to be sold.

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 Think – Pair – Share
Tech Engineering Inc. makes a consumer product for which
the following cost data are available.
 Fixed cost/ year = $120,000
 Variable costs/ unit = $15
i. Determine the breakeven volume if each unit can be sold
for $40.

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 Think – Pair – Share
Tech Engineering Inc. makes a consumer product for
which the following cost data are available.
 Fixed cost/ year = $120,000
 Variable costs/ unit = $15
ii. If a net profit of $100,000 is required, determine the
number of units that needed to be sold.

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