ENGINEERING

ECONOMIC ANALYSIS
IE-305
 INTRODUCTION TO
ENGINEERING ECONOMY
• What is Your Role as an Engineer?
– Build projects
– Design projects
– Evaluate projects
– Propose projects
– Define problems
–… Increasing complexity-
Decreasing certainty-
More possibilities-
Greater need for imagination
and leadership
…
Elements of Project Evaluation

• Estimate the time, resources, and other costs

of building the project,
• Determine the allocation of any kind of
resources
• Determine how the project can be financed,
• Support a comparison of costs and benefits
– Financial,
– Non-financial,
• Provide a process for dealing with
controversies.
ENGINEERING ECONOMY
• Engineering is concerned with the
cost effective use of scientific
knowledge to benefit humankind.

• Economics deals with the

interactions between people and
wealth.

• We will be studying the intersection

of Engineering and Economics.
ENGINEERING ECONOMY
ENGINEERING ECONOMY
• How to compare the economic value
of alternative design options?
Learning Objectives

Methodology:
• Apply the basic methods of engineering
economics in evaluating projects,
• Develop and apply simple models for
estimating costs and resources required for
projects.
Learning Outcomes
• To identify the principles and methods necessary to
evaluate and select engineering alternatives
• To acquire cost concepts and estimation techniques
• To discuss the concepts of time value of money and
interest rates.
• To recognize, formulate, and analyze cash flow
models in practical situations.
• To analyze cash flow series using present value,
future worth, annual worth, and rate of return
methods.
• To develop cash flow series considering the effects
of inflation, depreciation and taxes.
 CHAPTER-11

ESTIMATING COSTS
INTRODUCTION TO COST
 What Do Organizations Produce?

• Physical output (products)

• Non-Physical output (services)
• Monetary income (profits)
 What Inputs Do They Use?

• People’s time and services (labor)

• Materials and supplies
– Raw materials used to make their final products,
– Indirect materials (lubrication oil, etc.),
– Electric power and other energy inputs.
• Capital (money), which is used to pay for:
– Land and buildings;
– Producer goods (e.g., tools, equipment);
– Taxes.
 Cost
• What is the definition of cost?
– Cost is the price which has to be paid in order to
achieve a specific objective.

Costs

Direct costs Indirect costs

Direct material cost Indirect material cost

Direct labor cost Indirect labor cost

 Direct and Indirect Costs

• Direct costs can be reasonably measured and

allocated to a specific output or work activity
e.g. labor and material directly allocated with a
product, service or construction activity.

• Indirect costs are difficult to allocate to a

specific output or activity e.g. costs of common
tools, general supplies, and equipment
maintenance.
In Their Tendency to Vary With Volume or Activity

• Fixed costs
• Unaffected by changes in activity level, e.g., insurance and
taxes on facilities, general management and administrative
salaries, license fees etc.

• Variable costs
• Vary in total with the quantity of output, e.g., costs of
material and labor used in a product or service.
Fixed & Variable Costs of a Car
• Gasoline and lubricant
• Cost of material and labor
• Tires
• Raw material cost
• Depreciation
• Registration
• Garage rent
• Insurance
• Taxes
Fixed & Variable Costs of a Car
• Gasoline and lubricant Variable cost:
Their magnitude
• Cost of material and labor is determined
• Tires solely by the
number of miles
• Raw material cost driven
• Depreciation
Fixed costs:
• Registration Remain
• Garage rent essentially the
same regardless
• Insurance of how much the
• Taxes car is driven
Example

A company in the process industry

produces a chemical compound that is sold
to manufacturers for use in the production
of certain plastic products. The plant that
produces the compound employs
approximately 300 people. Develop a list of
several cost elements that are related with
this company.
• Executive salaries and the related cost of benefits
• Salaries and other expenses associated with operating a legal department
• Operation and maintenance (O&M) expenses for physical facilities
(buildings, parking lots, landscaping, etc.)
• Insurance, property taxes, and any license fees
• Other administrative expenses (personnel not directly related to
production; copying, duplicating, and graphics support; light vehicle
fleet; etc.)
• Interest cost on borrowed capital

• Direct labor
• Materials used in the product or service
• Electricity, lubricating and cutting oil, and so on for equipment used to
produce a product or deliver a service
• Replacement parts and other maintenance expenses for jigs and fixtures
• Maintenance material and replacement parts for equipment used to
produce a product or deliver a service
• The portion of the costs for a support activity (to production or service
delivery) that varies with quantity of output (e.g., for central compressed
air support: electricity, replacement parts, and other O&M expenses)
Fixed Cost Elements:
• Executive salaries and the related cost of benefits
• Salaries and other expenses associated with operating a legal department
• Operation and maintenance (O&M) expenses for physical facilities
(buildings, parking lots, landscaping, etc.)
• Insurance, property taxes, and any license fees
• Other administrative expenses (personnel not directly related to
production; copying, duplicating, and graphics support; light vehicle
fleet; etc.)
• Interest cost on borrowed capital
Variable Cost Elements:
• Direct labor
• Materials used in the product or service
• Electricity, lubricating and cutting oil, and so on for equipment used to
produce a product or deliver a service
• Replacement parts and other maintenance expenses for jigs and fixtures
• Maintenance material and replacement parts for equipment used to
produce a product or deliver a service
• The portion of the costs for a support activity (to production or service
delivery) that varies with quantity of output (e.g., for central compressed
air support: electricity, replacement parts, and other O&M expenses)
Capital cost / First Cost / Investment Cost
CAPEX
• The cost or total amount of investment
required for getting an activity started:
– Occurs only once for any given activity;
– Typically assumed to be paid in the beginning;
– Typically used for capital (land, buildings, tools,
equipment), not operating expenses.
Operating Costs
OPEX
• The costs of doing business (typically not
including depreciation).
• Includes both direct and indirect costs, but
not capital.
• Examples: Materials and supplies, wages and
salaries, fuel, water, electric power, taxes,
insurance…
COST ESTIMATION APPROACH
 Cost-Estimation
• Every organization needs:
– Metrics to track progress & determining whether a
proposed product can be made and distributed at a profit,
• Price = cost + profit contract
• Selling price for quoting or bidding or evaluate a contract.
– A starting point for improvement (Benchmarking),
– To describe the process by which the present and future
cost consequences of engineering designs are forecasted,
– To make profit or increase value.
• One bad project may take several good ones to recover
the loss!
“Formal cost estimating can roughly
double the probability that the project will
be completed successfully.”
Capers Jones, Estimating Software Costs, McGraw Hill, 1998
 Cost Estimating Approaches

• Determining product costs & selling price,

• Determining competitive prices,
• Approaches:
– Bottom-Up Approach: treats the required price as
an output variable and the cost estimates as input
variables. Preferred when pricing is not the
dominant in competition.
– Top-Down Approach: treats the competitive price
as an input variable and the cost estimates as
output variables. Preferred to encourage innovation
or new design.
Accuracy of the Estimates
COST
TYPE ACCURACY STAGE
ESTIMATE
Order of magnitude
±20% Initial evaluation
estimates
Semi-detailed or Preliminary
±15%
budget estimates design
Definite (detailed) Detailed design /
±5%
estimates construction
Sources of Estimating Data

• Accounting records,
• Other sources within the firm,
• Sources outside the firm,
• Research & Development.
 Estimating Models

• Unit Technique
• Indexes (Ratio Technique)
• Factor Technique
• Parametric Cost Estimating
– Power-Sizing Technique (Exponential Model)
• Analysis of product price and cost:
– Establishing price in relation to competition,
– Establishing product price as a markup to cost.
 Unit Technique
• Involves a “per unit factor” that can be estimated
effectively.
• Examples:
– Capital cost of a plant per kilowatt of capacity;
– Revenue per customer served;
– Operating cost per mile;
– Construction cost per square foot;
– Maintenance cost per hour.

Cost = unit cost x capacity per unit

Example
We need a preliminary estimate of the cost of a
particular house. Use the factor of, say, $55 per
square meter and assume that the house is
approximately 2,000 square meter.

Estimated cost of the house = $55 x 2,000

= $110,000
Indexes
 Consumer Price Indexes in Turkey
Turkish Statistical Institute, (2020). Consumer price data.

Tüketici fiyat endeks rakamları (2003=100)

Consumer price index numbers (2003=100)
Ocak Şubat Mart Nisan Mayıs Haziran Temmuz Ağustos Eylül Ekim Kasım Aralık
January February March April May June July August September October November December
2003 94.77 96.23 98.12 99.09 100.04 100.12 99.93 100.09 101.44 102.38 103.68 104.12
2004 104.81 105.35 106.36 106.89 107.35 107.21 107.72 108.54 109.57 112.03 113.50 113.86
2005 114.49 114.51 114.81 115.63 116.69 116.81 116.14 117.13 118.33 120.45 122.14 122.65
2006 123.57 123.84 124.18 125.84 128.20 128.63 129.72 129.15 130.81 132.47 134.18 134.49
2007 135.84 136.42 137.67 139.33 140.03 139.69 138.67 138.70 140.13 142.67 145.45 145.77
2008 146.94 148.84 150.27 152.79 155.07 154.51 155.40 155.02 155.72 159.77 161.10 160.44
2009 160.90 160.35 162.12 162.15 163.19 163.37 163.78 163.29 163.93 167.88 170.01 170.91
2010 174.07 176.59 177.62 178.68 178.04 177.04 176.19 176.90 179.07 182.35 182.40 181.85
2011 182.60 183.93 184.70 186.30 190.81 188.08 187.31 188.67 190.09 196.31 199.70 200.85
2012 201.98 203.12 203.96 207.05 206.61 204.76 204.29 205.43 207.55 211.62 212.42 213.23
2013 216.74 217.39 218.83 219.75 220.07 221.75 222.44 222.21 223.91 227.94 227.96 229.01
2014 233.54 234.54 237.18 240.37 241.32 242.07 243.17 243.40 243.74 248.37 248.82 247.72
2015 250.45 252.24 255.23 259.39 260.85 259.51 259.74 260.78 263.11 267.20 268.98 269.54
2016 274.44 274.38 274.27 276.42 278.02 279.33 282.58 281.76 282.27 286.33 287.81 292.54
2017 299.74 302.17 305.24 309.23 310.61 309.78 310.24 311.85 313.88 320.40 325.18 327.41
2018 330.75 333.17 336.48 342.78 348.34 357.44 359.41 367.66 390.84 401.27 395.48 393.88
2019 398.07 398.71 402.81 409.63 413.52 413.63 419.24 422.84 427.04 435.59 437.25 440.50
2020 446.45 448.02 450.58 454.43 460.62 465.84 468.56 472.61 477.21 487.38 498.58 504.81
2021 513.30 517.96 523.53 532.32 537.05 547.48 557.36 563.60 570.66
Example
A certain index for the cost of purchasing a
CNC machine is keyed to 2003, where its
baseline value was set at 94.77. Company
XYZ rented a similar CNC in 2003 for
$100,000. This same company must purchase
another CNC of the same size in 2010. The
index in 2010 is 174.07.
Example
A certain index for the cost of purchasing a
CNC machine is keyed to 2003, where its
baseline value was set at 94.77. Company
XYZ rented a similar CNC in 2003 for
$100,000. This same company must purchase
another CNC of the same size in 2010. The
index in 2010 is 174.07.

Approximate cost of new CNC =

C2010 = $100,000 (174.07/94.77) = $183,676
 Factor Technique
• The factor technique is an extension of the unit
technique:
C = cost being estimated.
Cd = cost of the selected component d that is estimated
directly.
fm = cost per unit of component m.
Um = number of units of component m.

C   Cd   f mU m
d m
Example
We need a refined estimate of the cost of the
house. Assume that the house is
approximately 2,000 square feet of living
space, has one porch and two garages. Use
the factor of, say, $50 per square foot of
living space, $5,000 per porch and $8,000
per garage.
Example
We need a refined estimate of the cost of the
house. Assume that the house is
approximately 2,000 square feet of living
space, has one porch and two garages. Use
the factor of, say, $50 per square foot of
living space, $5,000 per porch and $8,000
per garage.

Estimated cost of the house =

$50 x 2,000 + $5,000 + ($8,000 x 2)
= $121,000
 Power-Sizing Technique
• Also sometimes referred to as the exponential model;
• Often used to cost industrial plants and equipment;
• Use of historical data and statistical techniques to predict
future costs.
CA = cost for plant A
CB = cost for plant B
SA = size of plant A
SB = size of plant B
X = cost-capacity factor to reflect economies of scale

X X
CA  S A  S 
  or C A  CB  A 
CB  S B   S B 
 How to combine index and power-sizing?

• To have more powerful estimates, we can combine

indexes and power-size equations.
 How to combine index and power-sizing?

• To have more powerful estimates, we can combine

indexes and power-size equations.
Example
• Make a preliminary estimate of the cost of
building a 600-MW fossil fuel power plant. It
is known that a 200-MW plant cost $100
million 20 years ago when the appropriate
cost index was 400. That cost index is now
1,200. The power-sizing factor is 0.79.
Example
• Make a preliminary estimate of the cost of
building a 600-MW fossil fuel power plant. It
is known that a 200-MW plant costed $100
million 20 years ago when the appropriate
cost index was 400. That cost index is now
1,200. The power-sizing factor is 0.79.

Today’s estimated cost of a 600-MW plant =

 Top-Down Approach (Target Costing)

• What to produce & at what cost to produce?

• Uses historical data from similar engineering
projects,
• Used to estimate costs, revenues, and other
parameters for current project,
• Modifies original data for changes in inflation /
deflation, activity level, weight, energy
consumption, size, etc.,
• Best use is early in estimating process.
Procedure:
• Conduct market survey and determine the
selling price of best competitor’s product,
• Set profit margin,
• Compute target cost (TC),
• Compute total manufacturing cost (TMC),
• Compare TC & TMC,
• if TMC > TC go value engineering process.
• if TMC<TC, go from desing to detailed design.
If cannot, abandon the product.
– TC = Competitor’s price – Desired profit or
– TC = Competitor’s price / (1 + profit margin)
 Example

• Competitor’s price is $27.50.

• Profit margin = 10%. Thus
– Target Cost = $27.50/(1+0.1) = $25
– Assume TMC = $26
– Since TMC > Target Cost, we must work backwards
from the TMC and find out to reduce it.
 Bottom-Up Approach (Design to Price)

• What to produce & how to price the product?

• More detailed cost-estimating method,
• Attempts to break down project into small,
manageable units and estimate costs,
• Smaller unit costs added together with other
types of costs to obtain overall cost estimate,
• Works best when detail-concerning desired
output is defined and clarified.
Procedure:
Example - Manufacturing
• Direct labor costs are estimated via the unit
technique. 36 direct labor hours are required to
produce 50 units and the pay rate is $10.54 per hour.
Indirect costs are often allocated using factor
estimates. Planning labor and quality control are
estimated at 12% and 11% of direct labor cost.
Example
• Factory overhead and general and administrative
expenses are estimated as 105% and 15% of total
labor costs. Total production materials cost for the
50 unit is $167.17. A direct estimate of $28.00
applied to outside manufacturing.
Example
• Packing costs are estimated as 5% of all previous
costs. Costs of other miscellaneous charges are
figured in as 1% of the current subtotal. Facility
rental is estimated at $0.
Example
• The price of a product is based on the
overall cost of making the item plus a built-
in profit (profit margin). Here we use a
profit margin of 10%.

• As a result unit price = ?