Engineering Economy

Chapter 3
Cost Estimation Techniques
The objective

present various methods for estimating

important factors in an engineering economy
study.
 Estimating the future cash flows for feasible
alternatives is a critical step in engineering
economy studies. Estimating costs, revenues,
useful lives, residual values, and other pertinent
data can be the most difficult, expensive, and
time-consuming part of the study.
 I. Introduction

1. Results of cost estimating are used for a variety of purposes.

• Setting selling prices for quoting, bidding, or evaluating contracts.

• Determining if a proposed product can be made and distributed at a
profit.
• Evaluating how much capital can be justified for changes and
improvements.
• Setting benchmarks for productivity improvement programs.
 2. The two fundamental approaches are “top-down” and
“bottom-up.”

• Top-down uses historical data from similar projects. It is best

used when alternatives are still being developed and refined.
• Bottom-up is more detailed and works best when the detail
concerning the desired output (product or service) has been
defined and clarified.
 2. The two fundamental approaches are “top-down” and
“bottom-up.”

• Top-down uses historical data from similar projects. It is best

used when alternatives are still being developed and refined.
• Bottom-up is more detailed and works best when the detail
concerning the desired output (product or service) has been
defined and clarified.
Example:
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. In our
solution, we outline the two basic approaches just discussed for estimating
these costs.
Top-down

A top-down approach would take the published cost of a four-year degree

at the same (or a similar) university and adjust it for inflation and
extraordinary items that an incoming student might encounter, such as
fraternity/sorority membership, scholarships, and tutoring. For example,
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 full-time tuition and fees, university housing, and a
weekly meal plan. Not included are the costs of books, supplies, and other
personal expenses. For our initial estimate, these “other” expenses are
assumed to remain constant at $6,000 per year.
Bottom-up
II. An integrated approach
The integrated cost estimation approach has three
major components:

II.1 Work breakdown structure (WBS)

II.2 Cost and revenue structure (classification)
II.3 Estimating techniques (models)
II.1 Work Breakdown Structure (WBS)

• A basic tool in project management

• A framework for defining all project work elements and their
relationships, collecting and organizing information,
developing relevant cost and revenue data, and management
activities.
• Each level of a WBS divides the work elements into
increasing detail.
The WBS
diagram
 A WBS has other characteristics.

• Both functional and physical work elements are included.

• The content and resource requirements for a work element
are the sum of the activities and resources of related sub-
elements below it.
• A project WBS usually includes recurring and nonrecurring
work elements.
 II.2 Cost and Revenue Structure
• Used to identify and categorize the
costs and revenues that need to be
included in the analysis.
• The life-cycle concept and WBS
are important aids in developing
the cost and revenue structure for a
project.
• Perhaps the most serious source of
errors in developing cash flows is
overlooking important categories
of costs and revenues.
 II.3 Estimating Techniques (models)
REMEMBER! The purpose of estimating is to develop cash-flow
projections—not to produce exact data about the future, which is virtually
impossible.
Cost and revenue estimates can be classified according to detail, accuracy, and
their intended use as follows:

• Order-of-magnitude estimates (±30%)

• Semidetailed, or budget, estimates (±15%)
• Definitive (detailed) estimates (±5%)
- The level of detail and accuracy of estimates depends on:

• time and effort available as justified by the importance of

the study,
• difficulty of estimating the items in question,
• methods or techniques employed,
• qualifications of the estimator(s), and
• sensitivity of study results to particular factor estimates.
- A variety of sources exist for cost and revenue estimation:

• Accounting records: good for historical data, but limited for

engineering economic analysis.
• Other sources inside the firm: e.g., sales, engineering,
production, purchasing.
• Sources outside the firm: U.S. government data, industry
surveys, trade journals, and personal contacts.
• Research and development: e.g., pilot plant, test marketing
program, surveys.
III. Selected Estimating techniques
These models can be used in many types of estimates.

III.1 Indexes
III.2 Unit technique
III.3 Factor technique
 III.1 Indexes (I)
provide a means for developing present and future cost and
price estimates from historical data.

k = reference year for which cost or price is known.

n = year for which cost or price is to be estimated (n>k).
Cn = estimated cost or price of item in year n.
Ck = cost or price of item in reference year k.

Indexes can be created for a single item or for multiple

items.
III.1 Indexes (I)
A certain index for the cost of purchasing and installing utility boilers is
keyed to 1988, where its baseline value was arbitrarily set at 100.
Company XYZ installed a 50,000-lb/hour boiler for $525,000 in 2000
when the index had a value of 468. This same company must install
another boiler of the same size in 2017. The index in 2017 is 542. What
is the approximate cost of the new boiler?
III.2 The unit technique,
is one that is widely known and understood.
A “per unit factor” is used, along with the appropriate number of
units, to find the total estimate of cost. An often used example is the
cost of a particular house. Using a per unit factor of, say, $120 per
square foot, and applying that to a house with 3,000 square feet,
results in an estimated cost of $120 x 3,000 = $360,000.

This techniques is useful in preliminary estimates, but using average

costs can be very misleading.
III.3 The factor technique,
is an extension of the unit technique where the products of
several quantities are summed and then added to components
estimated directly.

C = cost being estimated

Cd = cost of the selected component d estimated directly
fm = cost per unit of component m
Um = number of units of component m
III.3 The factor technique,

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 for the two
directly estimated components, we can calculate the
total estimate as
IV. Parametric cost estimating,

is the use of historical cost data and statistical techniques (e.g.,

linear regression) to predict future costs. Parametric models are
used in the early design stages to get an idea of how much the
product (or project) will cost, on the basis of a few physical
attributes (such as weight, volume, and power).
IV.1 The power-sizing technique (exponential model)
is frequently used for developing capital investment estimates for
industrial plants and equipment.

(both in $ as of the point in time

for which the estimate is desired)

(both in the same physical units)

IV.2 A learning curve,
reflects increased efficiency and performance with repetitive
production of a good or service. The concept is that some
input resources decrease, on a per-output-unit basis, as the
number of units produced increases.
 Most learning curves assume a constant percentage
reduction occurs as the number of units produced is doubled.
Example:
Assume the first unit of production required 3 hours time for
assembly. The learning rate is 75%. Find:
(a) the time to assemble the 8th unit, and
(b) the time needed to assemble the first 6 units.
V. Cost estimation in the design process
V.1 “Bottom-up” cost estimating,
is commonly used to make decisions about what to
produce and how to price products.

Major types of costs to estimate are

• tooling costs,
• manufacturing labor costs,
• material costs,
• supervision,
• factory overhead, and
• general and administrative costs.
V.2 “Top-down,” or target costing,
focuses on “what should the product cost” instead of
“what does the product cost,” with the aim of designing
costs out of products before they enter the manufacturing
process. Costs are viewed as an input to the design
process.

or
 V.3 The value engineering (VE),

is to provide required product functions at a minimum cost.

Below are some sample VE questions than should be asked:

• Are all the functions provided • Are all the machined parts
required by the customer? necessary?
• Can less expensive material be • Would product redesign eliminate
used? quality problems?
• Can the number of different • Is the current level of packaging
materials used be reduced? necessary?
• Can fewer parts be used? • Can a part designed for another
product be used?