Engineering Economics

21S3101

Engineering Management
Del Institute of Technology
 Cost estimation

An approximation of the probable cost of a product,

program, project or operation, computed based on
the basis of available information.

Purpose of Cost Estimation

• To establish the selling price of a product
• To determine the most economical process
• To make buy decisions
• To prepare production budget

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 Example of Costs

• Acquisition costs
• Annual labor
• Annual maintenance
• Material costs
• Interest rates for investments
• Insurance costs
• Tax rates
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 Example: Costs for Business Project “Bakery Shop”

In the beginning we have pay And then to operate we

one time for: spend every month:
• Rent deposit • Rent
• Renovations to our shop • Utilities (Electric bill,
• Decorations/furniture to Water bills, telephone bill)
our shop • Monthly supplies (flour,
• Business Permit eggs, etc.)
• Hiring Cost • Packaging (paper bag)
• Equipment • Salary of workers
• Miscellaneous • Insurance

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 CAPEX & OPEX

• Capital Expenditures (CAPEX) are funds that a business

uses to purchase goods and services that expand its
ability to generate profits.
• Operating Expenses (OPEX) are the ongoing costs a
company incurs to run its daily business.
“Bakery Shop”
Capital Expenditures : Operating Expenses :
• New Building • Wages
• Rent Deposit • Utilities
• Renovasions • Rent
• Decorations • Monthly Supplies
• Equipment • Maintenance 21S3101
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 Types of Estimate

Rough Estimates
Order of magnitude estimates used for high-level planning, for
determining project feasibility, and in a project’s initial planning and
evaluation phases.
Semidetailed Estimates
Used for budgeting purposes at a project’s conceptual or preliminary
design stages. These estimates are more detailed, and they require
additional time and resources.
Detailed Estimates
Used during a project’s detailed design and contract bidding phases.
These estimates are made from detailed quantitative models,
blueprints, product specification sheets, and vendor quotes.
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 Accuracy versus cost trade-off in estimating

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Sumber : D. G. Newnan, et al. 2012. Engineering Economics

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 How to Estimate Cost?

Survey Benchmarking Cost

to to existing modeling
business
suppliers

Estimate Cost

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 Cost Estimation Model

• Per-Unit Model
• Segmenting Model
• Cost Indexes
• Power-Sizing Model
• Improvement and Learning Curve

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 Per-Unit Model

Uses a “per unit” factor, such as cost per square foot, to

develop the estimate desired. This is a very simplistic yet
Per-Unit Model useful technique, especially for developing estimates of the
rough or order-of-magnitude type.

Example :
Andi interested to build in a new home that is constructed with a certain type
of material and has a specific construction style. Based on this information a
contractor quotes a cost of $50 per square foot. If Andi interested build a
2000-square-foot floor plan, how the cost would thus be?

Cost estimation = $50/square foot x 2.000 square foot

= $100.000

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 Segmenting Model
An estimate is decomposed into its individual components,
Segmenting
estimates are made at those lower levels, and then the
Model estimates are aggregated (added) back together.

Example :
Estimate the material costs for each of the components Grass Grabber
Cost Cost Item Cost Estimate
Cost Item
Estimate
Controls The total material
Chassis
Deck $7.40
Handle assembly $3.85 cost estimate
Engine linkage $8.55
Wheels $10.2 Blade linkage $4.7 = $22.45 + $72.70
Axles $4.85 Speed control linkage $21.5 + $52.70 + $25.60
Total $22.45 Drive control
Drive train assembly
$6.7 = $173.45
Engine $38.50 Cutting height adjuster $7.4
Starter assembly $5.9 Total $52.70
Transmission $5.45 Cutting/Collection system
Drive disc assembly $10 Blade assembly $10.80
Clutch linkage $5.15 Side chute $7.05
Belt assemblies $7.7 Grass bag and adapter $7.75
Total $72.70 Total $25.60 21S3101
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 Cost Indexes

• Cost Indexes can be used to account for historical

changes in costs

• Cost index data are available from variety of

sources : Data BPS

• Equation :
Cost at time A = Index value at time A
Cost at time B Index value at time B

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 Cost Indexes
Example :
Based on our research, the cost of the corner shop is
$10.000 five years ago with cost index value of 144. Now,
the cost index value of that shop is 180. How much in
estimation should we pay for this corner shop?
$10.000 144
=
Cost at time B 180

Cost at time B = $10.000 x 180

144
= $12.500
Cost estimation to pay for the corner shop 21S3101
is $12.500 Engineering Economics

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 Cost Indexes
Example :
Miriam 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 costs :
• 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
Material costs :
• 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 21S3101
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 Cost Indexes

Labor

Annual cost today = Index value today

Annual cost 10 years ago Index value 10 years ago

Annual cost today = 188 x $575.500

124
= $871.800

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 Cost Indexes

Material

Annual cost today = Index value today

Annual cost 3 years ago Index value 3 years ago

Annual cost today = 715 x $2.455.000

544
= $3.227.000

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 Power-Sizing Model

The power-sizing model is used to estimate the costs

of industrial plants and equipment. The power-sizing
models account explicitly for economies of scale.

The power-sizing model uses the exponent (x), called

the power-sizing exponent, to reflect economies of
scale in the size or capacity:

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 Power-Sizing Model

• Power-sizing exponent (x) is available from

variety of sources.
• Power sizing (x) can be :
• x = 1.0 means linear cost-versus size relationship, no
economy of scale
• x < 1.0 means economy of scale
• x > 1.0 means diseconomy of scale
• “Size” is used here in a general sense to indicate
physical size, capacity or some appropriate
comparison unit.
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 Example Power-Sizing Exponent Values

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 Power-Sizing Model

Example :
Miriam has been asked to estimate the today’s cost of
2500ft2 heat exchange system for the new plant being
analyzed. She has the following data :
• Her company paid $50,000 for 1000ft2 heat
exchanger 5 years ago
• Heat exchangers within this range of capacity
has a power sizing exponent (x) of 0.55
• Five years ago the Heat Exchanger Cost Index
(HECI) was 1306; it is 1487 today
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 Power-Sizing Model
Miriam will first estimate cost of the 1000-ft2 exchanger to one that is
2500 ft2 using the 0.55 power-sizing exponent.
x
(
Cost of 2500ft2
=
“Size” of 2500ft2 (
Cost of 1000ft2 “Size” 1000ft2
( 0.55
=(
2500
Cost of 2500ft2
1000
x $50.000 = $82.800
Miriam knows that 82,800 reflects only the scaling up of the cost of the
1000ft2 model to 2500ft2 model. Now she will use following equation of
cost index model to determine the today’s cost of equipment.
Equipment cost today Index value today
=
Equipment cost 5 years ago Index value 5 years ago
1.487
Equipment cost today =
1.306
x $82.800 = $94.300
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 Power-Sizing Model

Practice :

We would like to buy a refrigerator for our new corner-

shop that has more 50% more capacity than our current
refrigerator (which cost $1000). The appropriate power
sizing exponent for this type of equipment is 0.725. Use the
power-sizing model to estimate the cost of this new
refrigerator!

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 Improvement and the Learning Curve

Learning curve cost estimating is based on the assumption

that as particular task is repeated, the operator systematically
becomes quicker at performing the task  captures the
relationship between task performance and task repetition.

As output doubles the unit production time will be reduced to

some fixed percentage  the learning curve percentage or
learning curve rate.

For example, a learning curve rate of 70% represents much

faster learning than a rate of 90%.
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 Improvement and the Learning Curve
Equation :

TN = Tinitial x Nb

Where

TN = time requirement for the Nth unit of production

Tinitial = time requirement for the first (initial) unit of production
N = number of completed units (cumulative production)
b = learning curve exponent
The equation for learning curve exponent

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 Improvement and the Learning Curve

Example :

Calculate the time required to produce the hundredth unit of

a production run if the first unit took 32 minutes to produce
and the learning curve rate for production is 80%.

Solution :
T100 = T1 × 100b
T100 = T1 × 100 log 0.80/log 2.0
T100 = 32.0 × 100-0.3219
T100 = 7.27 minutes
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 Improvement and the Learning Curve

Example :

Calculate the time required to produce the hundredth unit of

a chocolate cake if the first cake took 52 minutes (not
including baking time) to produce and the learning curve rate
for production is 80%.

Solution :
T100 = T1 x 100 log 0.80/log 2.0
T100 = 52.0 x 100-0.3219
T100 = 11.80 minutes
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 Benefits Estimation

Benefits estimation  An approximation

of the probable revenue/ income from
doing a business, running a project, etc.

Example of income in bakery business :

 Sales of bakery products
 Sales of beverages

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 CASH FLOW DIAGRAMS

• Summarizes the flow of money over time

• Can be represented using a spreadsheet

An example cash flow diagram (CFD)

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 Cash Flow Diagram in Spreadsheets

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 Handbook

• Donald G. Newnan et al., Engineering Economic Analysis

Eleventh Edition, Oxford University Press: New York, 2012.

• Chan S. Park, Fundamentals of Engineering Economics,

Pearson Education Limited: Edinburgh Gate, 2013.

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