COST ESTIMATING AND ANALYSIS

MANJU
SWAPNALI
RAJESH
AKBAR
SHAILESH
SHRIKHANT
PRITISH
INTRODUCTION TO COST ESTIMATING
The National Estimating Society has defined Cost
Estimating1as:
The art of approximating the probable cost of something
based on information available at the time.
Estimates of cost function has been divided in to two parts:
short-run and long run cost functions
The short-run cost function enables us to determine the
optimal level of output and the price to charged
The long-run cost function is essential in planning for the
optimal scale of plant for the firm to build in the long run
Benefits
cost estimating is a powerful tool because it:
Leads to a better understanding of the problem,
Improves management insight into resource allocation
problems, and
Provides an objective baseline to measure progress.
Helps to distinguish between different costs
Types of cost estimates
 Four types of cost estimates represent various levels of
reliability .
 Conceptual Estimate: Rough order of magnitude or back of the
envelope.
 Often inaccurate because there are too many
unknowns.
 Preliminary Estimate: Used to develop initial budget, more
precise.
 Detailed Estimate: Serves as a basis for daily project control.

 Definitive Estimate: Accuracy should be within 10% of final

cost.
Steps
All cost estimates are constructed by the following
tasks:
Identifying the purpose and scope of the new system.
Newsoftware development, software reuse,
COTS integration, etc.
Choosing an estimate type.
Conceptual, preliminary, detailed, or definitive
type estimate
Identifying system performance and/or technical goals.
Cont’d……………………..
Laying out a program schedule.
Selecting a cost element structure (CES).
Collecting, evaluating, and verifying data.
Choosing, applying, cross-checking estimating methods
to develop the cost estimate.
Performing risk and sensitivity analysis
Time-phasing the cost estimate by fiscal year for cash
flow purposes.
Example: 4 years to develop and 10 years
operations and support beginning in FY2003
Providing full documentation.
concepts of cost
Historical & Current
Explicit & Implicit
Incremental & Sunk
Short run & long run
Economies of scale & diseconomies of scale
Private & social cost
Opportunity cost
Money cost
Real cost
Economic & accounting cost
ECONOMIES AND DISECONOMIES
OF SCALE
ECOMIES OF SCALE

EXTERNAL OR
INTERNAL OR
PECUNIARYCECONO
REAL ECONOMIES MIES
 DISECONOMIES OF
SCALE

INTERNAL EXTERNAL
DISECONOMIES DISECONOMIES
Theories of cost in short-run
Fixed cost
Variable cost
Total Cost
Total Fixed Cost
Total Variable Cost
Cost functions : short-run and long-run
In economics, two types of cost functions are used
more
1: The short-run cost functions :In which some factors of
production are fixed and the firm depends only on
variable factors to increase the output
2:The long-run cost functions: in this all the factors are
variable and the quantity of output can increased at
any level
Figure of TFC,TVC,TC
TC
80-
70-
TVC
60-
50-
40-
30-
TFC
20-
10-
0- 2 4 6 8 10 12 14 16 18
Short-run cost curves
To understand the per unit profit, the firm compares
per unit cost with per unit price
Thus the concepts of AFC,AVC, ATC & marginal cost
Marginal cost is the increase in the total cost
consequent upon a small increase in output, since the
fixed cost remains unchanged
Cost Function Formulas
TC= TFC+ TVC
AFC= TFC/ Q
AVC= TVC/Q
ATC= AFC+AVC = TC/Q
MC= ∆ TC/ ∆ Q = ∆ VC/ ∆ Q
FIGURE OF AFC,AVC,ATC
MARGINAL COST
The marginal cost is the cost consequent upon a small
increase in output . In symbols,

MC= ∆TC or ∆TVC

∆Q ∆Q
Relationship between MC and AC
When the mc curve is below the ac curve means mc is
less than ac
If the mc curve is above the ac curve means mc is more
than ac
The mc curve intersects the ac curve at its minimum
point
FIGURE OF MC & AC
Figure of AVC,AFC,ATC & MC
Long Run Cost
A firms LTC is derived from the firms expansion path
and shows the minimum long run total cost of
producing various levels of output.
It depends on the firms ability to vary all inputs.
LMC refers to change in LTC per unit/ change in
output.
Long run Cost Functions
Long run Average Cost (LAC)
LAC= LTC/Q
Long run Marginal Cost (LMC)
LMC= ∆LTC/ ∆Q
 theories of long-run cost curves
Long period economic efficiency: the firm when uses
plant of relatively small size, it produces output much
larger than is technologically optimum yet the cost
remains low because it becomes possible to reduce the
diseconomies of the large plant.
The long-run average cost curve
The long-run marginal cost curve
LONG RUN AVC & ATC
Learning curve concept
As firm gain experience in the production of a
commodity or service their average cost and marginal
cost of production usually declines because of:
[1]workers [2]managers[3] engineers[4] suppliers
This curve shows the decline in the average input cost
of production with rising cumulative total outputs
over time.
CONTD………
In simplest terms, the cost of manufacturing or
installing a unit should decrease as the number of
units involved increases.
As the number of units produced doubles, the cost per
unit decreases by a fixed percentage
The concept of learning curves is not new, originated
in the mid-1930’s with T.P. Wright in the Journal of
Aeronautical Sciences.
EXAMPLE
Say that the first 100 tasks of an installation took 10
hours per task and the next 100 averaged 8 hours per
task. Thus, the learning curve would be calculated as
follows:

Learning curve = 8 hours per task/10 hours per task =

0.8

Implies an 80% learning curve meaning an

improvement of 20% occurred between the first 100
tasks and next 200 tasks
FIGURE OF LEARNING CURVE
Cost Analysis
Cost-benefit analysis is a term that refers both to:
 helping to appraise, or assess, the case for a project or
proposal, which itself is a process known as project
appraisal; and
 an informal approach to making economic decisions of
any kind.
The formal process is often referred to as either CBA
(Cost-Benefit Analysis) or BCA (Benefit-Cost Analysis).
Types of Cost Benefit Analysis
Cost-effectiveness analysis
Economic impact analysis
Fiscal impact analysis
Social Return on Investment (SROI) analysis.
Application of CBA
Cost–benefit analysis is used mainly to assess the
monetary value of very large private and public sector
projects.
 This is because such projects tend to include costs and
benefits that are less amenable to being expressed in
financial or monetary terms (e.g., environmental
damage), as well as those that can be expressed in
monetary terms.
Private sector organizations tend to make much more use
of other project appraisal techniques, such as rate of
return, where feasible.
Key indicators for CBA
NPV (net present value)
PVB (present value of benefits)
PVC (present value of costs)
BCR (benefit cost ratio = PVB / PVC)
Net benefit (= PVB - PVC)
NPV/k (where k is the level of funds available)
Accuracy Problems
The accuracy of the outcome of a cost–benefit analysis
depends on how accurately costs and benefits have
been estimated
Eg. A peer-reviewed study of the accuracy of cost
estimates in transportation infrastructure planning
found that for rail projects actual costs turned out to
be on average 44.7 percent higher than estimated
costs, and for roads 20.4 percent higher
Steps of C-B analysis
A cost benefit analysis finds, quantifies, and adds all
the positive factors. These are the benefits.
 Then it identifies, quantifies, and subtracts all the
negatives, the costs.
The difference between the two indicates whether the
planned action is advisable.
The real trick to doing a cost benefit analysis well is
making sure you include all the costs and all the
benefits and properly quantify them.
Example of C-B analysis
As the Production Manager, you are proposing the
purchase of a $1 Million stamping machine to increase
output.
Step taken by the manager:
1. You itemize the benefits
2. Then you calculate the monthly cost of the machine,
by dividing the purchase price by 12 months per year
and divide that by the 10 years the machine should
last.
CONTD……..
3. You subtract your total cost figure from your total
benefit value and your analysis shows a healthy profit.
All you have to do now is present it to the VP, right?
Wrong. You've got the right idea, but you left out a lot
of detail.
Running of nos.
Since the cost benefit analysis relies on the addition of
positive factors and the subtraction of negative ones to
determine a net result, it is also known as running the
numbers.
Running of no's means all the no's
Benefits that should be included
Selling price should not be taken instead activity
based value
Benefits of replaced workers such as overheads cost,
cost of their benefits etc
Lower cost of material
More cost to be included
The typical failure of a cost benefit analysis is not including all the costs. In the
case of the stamping machine, here are some of the overlooked costs:
Floor Space
Will the machine fit in the same space currently occupied by the three workers?
Installation
What will it cost to remove the manual stampers and install the new machine?
Will you have to cut a hole in a wall to get it in or will it fit through the door?
Will you need special rollers or machinists with special skills to install it?
Operator?
Somebody has to operate the machine. Does this person need special training?
What will the operator's salary, including overhead, cost?
* Environment
Will the new machine be so noisy that you have to build soundproofing around
it? Will the new machine increase the insurance premiums for the company?
Draft of C-B analysis
Cost Benefit Analysis - Purchase of New Stamping Machine
(Costs shown are per month and amortized over four years)
Purchase of Machine .................... -$20,000
includes interest and taxes
Installation of Machine ..................... -3,125
including screens & removal of existing stampers
Increased Revenue .......................... 27,520
net value of additional 100 units per hour, 1 shift/day, 5 days/week
Quality Increase Revenue ..................... 358
calculated at 75% of current reject rate
Reduced material costs ...................... 1,128
purchase of bulk supply reduces cost by $0.82 per hundred
Reduced Labor Costs ....................... 18,585
3 operators salary plus labor o/h
New Operator ................................. -8,321
salary plus overhead. Includes training
Utilities ............................................ -250
power consumption increase for new machine
Insurance ......................................... -180
premiums increase
Square footage ...................................... 0
no additional floor space is required
Net Savings per Month ........................... $15,715 . themachine will save
your company over $15,000 per month, almost $190,000 a year.
BREAK-EVEN ANALYSIS
A calculation of the approximate sales volume required
to just cover costs, below which production would be
unprofitable and above which it would be profitable
Break-even analysis focuses on the relationship between
fixed cost, variable cost, and profit.
A breakeven analysis is used to determine how much
sales volume your business needs to start making a profit.
The breakeven analysis is especially useful when you're
developing a pricing strategy, either as part of a
marketing plan or a business plan.
FORMULA
break even point (for output) = fixed cost /
contribution per unit
contribution (p.u) = selling price (p.u) - variable cost
(p.u)
break even point (for sales) = fixed cost / contribution
(pu) * sp (pu)
EXAMPLE
Assume we are selling a product for £2 each.
Assume that the variable cost associated with
producing and selling the product is 60p.
Assume that the fixed cost related to the product (the
basic costs that are incurred in operating the business
even if no product is produced) is $1000.
In this example, the firm would have to sell (1000 /
(2.00 - 0.60) = 715) 715 units to break even
USES OF BREAK- EVEN ANALYSIS
Sales volume can be determined to earn a given
amount of returns on capital
Profit can be forecast if estimates of revenue and cost
are available.
Effect of change in the volume of sales, sale price, cost
of production, can be appraised.
Choice of products or processes can be made from the
alternatives available. Product-mix can also be
determined.
Impact of increase or decrease in fixed and variable
costs can be highlighted.
Cont’d…………..
Effect of high fixed costs and low variable costs can be
studied
Valid interfirm comparisons of profitability can be
made
Cash break-even chart helps proper planning of cash
requirements.
Helps to achieve economies of scale
Margin of safety can be determined
FIGURE OF BREAK-EVEN ANALYSIS
DEGREE OF OPERATING LEVERAGE
The percentage of fixed cost in a company's cost
structure.
Generally, the higher the operating leverage, the more a
company's income is affected by fluctuation in sales
volume.
The higher income vs. sales ratio results from a smaller
portion of variable costs, which means the company does
not have to pay as much additional money for each unit
produced or sold.
The more significant the volume of sales, the more
beneficial the investment in fixed costs becomes
 Case study
NPEC airlines has an evening flight from delhi to
chennai with an average of 80 passengers a return flight
the next afternoon with an average of 50 passengers.
The plane makes no other trip.The charge for the plane
remmaning in chennai overnight is $1,200 and would
be zero in delhi. The airline is contemplating the night
flight out of delhi and replacing it with a morning
flight. The estimated no of passengers is 70 in the
morning flight and 50 in the return afternoon flight.
The one-way ticket for any flight is $200. The operating
cost of the plane for each flight is $11,000. the fixed
costs for the are $3000 per day whether it flies or not.
Question?
(a) should the airline replace its night flight from delhi
with a morning flight?
(b) should the airline remain in business?
THANK YOU