DEFINITION OF BASELINE:

1- total revenue
should be used
and cost approach
consistently
2- differential approach

DEVELOPING CASH FLOWS

Engineering economic analyses procedure
7 steps

*The most important criterion in selecting the study

period-release to the decision situation.

This topic concentrates on step 3:


- Development of the net cash flow for each
alternative.
- Integrated approach
activities in step 3

to

accomplish

the

BEFORE DEVELOPING CASH FLOWS:

- Decide the WBS level(s) to use for developing
the cost and revenue estimates
- Organize cost and revenue information from
internal and external sources
- Assemble relevant data

THREE BASIC COMPONENTS

1. Work Breakdown Structure (WBS)
2. Cost and Revenue Structure (classification)
3. Estimating Techniques (Models)

WORK BREAKDOWN STRUCTURE (WBS)

To estimate future costs and revenues for an
alternative,
1) establish the viewpoint/perspective of the cash
flow
2) define the estimating baseline
3) define the study/analysis period

WBS-serves as a framework for defining all project

work elements and their interrelationships, collecting
and organizing information, developing relevant cost
and revenue data, and integrating project
management activities.

CE 22 Engineering Economy Developing Cash Flows

CE 22 Engineering Economy Developing Cash Flows

CHARACTERISTICS OF WBS
1. Inclusion of both functional and physical work
elements.
2. Other functional work elements- logistical support,
project management, marketing, engineering and
systems integration.
3. Physical work elements-parts that make-up a
structure, product, etc.
- require labor, material and other resources to
produce or construct.
4. Content and resource requirements for a work
element sum of the activities and resources of
related sub-elements below it.
5. Includes recurring and non-recurring work
elements.

- The life cycle defines a maximum time period

and establishes a range of cost and revenue
elements that need to be considered in
developing cash flows.
- Then WBS will allow the analyst to focus on
specifies.

STUDY PERIOD = LIFE CYCLE

Why?
1) Permits the consideration of all relevant costs
and revenues
2) Makes possible the explicit trade-off between
initial costs and future costs and revenues
* Accuracy of cost and revenue estimates increases
when length of study period decreases

COST AND REVENUE STRUCTURE

- used for identifying and categorizing the costs
and revenues that need to be included in the
analysis.

[The effort required developing cash flows increases

when study period increases.]

- LIFE CYCLE CONCEPT- DIVIDED INTO 2

GENERAL TIME PERIODS:
1) Acquisition Phase
2) Operation Phase
- Begins with identification of the need or
requirement and ends with retirement or
disposal.
CE 22 Engineering Economy Developing Cash Flows

CE 22 Engineering Economy Developing Cash Flows

ESTIMATES
NEEDED
FOR
A
TYPICAL
ENGINEERING ECONOMY STUDY
- judgement is required
- to determine study period
- to weigh which cost and revenue elements are
the most important
- which elements, even if drastically
misjudged, will not produce significant
changes in the estimated cash flows.
Most serious source of errors in developing cash
flows is overlooking important categories of cost and
revenues
- cost and revenue structure prepared in tabular
or checklist form
- technical familiarity is essential in ensuring
completeness of the structure.
AMONG THOSE TO BE CONSIDERED
1. Investment costs
2. Labor costs
3. Material costs
4. Maintenance costs
5. Property taxes and insurance
6. Quality and scrap costs
7. Overhead costs
8. Disposal costs
9. Revenues
10. Salvage value
CE 22 Engineering Economy Developing Cash Flows

ESTIMATING TECHNIQUES (MODELS)

Estimating-to develop cash flow projections
CLASSIFICATION OF COST AND REVENUE
ESTIMATES
{According to detail, accuracy and intended use}
1. Order of magnitude estimates {planning/initial
evaluation}
2. Semi-detailed or budget estimates
{preliminary/conceptual design)
3. Definitive (detailed) estimates {detailed
engg/construction}
(1) 30 to 50% accuracy (level 1 or 2 of WBS)
(2) 15% (level 2 and 3 of WBS)
(3) 5% (level 3 and so on of WBS)
LEVEL OF DETAIL &
ESTIMATES DEPENDENT

ACCURACY

OF

1) Time and effort available and justified by the

importance of the study
2) Difficulty of estimating the items in question
3) Methods or techniques employed
4) Qualifications of the estimator(s)
5) Sensitivity of study results to particular factors
estimates
5

CE 22 Engineering Economy Developing Cash Flows

As estimates become more detailed

- accuracy of estimate improves
- estimation cost increases dramatically

HOW ESTIMATES ARE ACCOMPLISHED

1. Conference

SOURCES OF ESTIMATING DATA

2. Comparison
approximation/estimating by analogy
selecting upper bound and lower bound

Delphi method involves cycles of questioning and

feedback in which the opinions of individual
participants are kept anonymous.

1) Accounting records
- prime source of info but often not suitable for
direct, unadjusted use.

3. Quantitative Techniques

LIMITATIONS
- Accounting system is rigidly categorize
- Std. Accounting conventions cause
misstatements of some types of financial info
to be built into the system
- Data have precision and implied
authoritativeness

SELECTED ESTIMATING TECHNIQUES

A. INDEXES
- dimensionless number that indicates how
costs and prices change with time.
UNWEIGHTED INDEX

2) Other sources within the firm

{engineering, sales, production, personnel, etc.}

C n1 C n 2
C
C

+
+  + nm +  + nM
C
Ck 2
C km
C kM
I n = k1
M

3) Sources outside the firm

a. published info
b. personal contacts
4) Research and development
- usually expensive

CE 22 Engineering Economy Developing Cash Flows

Where k = reference year

n = year for which an index is to be
determined (n > k);
M = total number of items in the index (1
m M);
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CE 22 Engineering Economy Developing Cash Flows

Cnm = unit cost (or price) of the mth item in

year n;
Ckm = unit cost (or price) of the mth item in
reference year k,

D. FACTOR TECHNIQUE
- extension of the unit technique

C = Cd + fmU m
d

GENERAL WEIGHTED INDEX or COMPOSITE

INDEX

In =

Where:

W1 (Cn1 / Ck1 ) + W2 (Cn 2 ) + ... + WM (CnM / CkM )

W1 + W2 + ...WM

C = cost being estimated

Cd = cost of the selected component d that is
estimated directly
fm = cost per unit of component m
Um = no.of units of components m.

E. ESTIMATING RELATIONSHIPS

Where WM = Weights on item 1 to M.

B. UNIT TECHNIQUE
- involves utilizing a per unit factor that can be
estimated effectively
e.g. construction cost per square meter fuel cost per
kilowatt-hour generated miles per gallon.

- cost and price estimating relationships are

mathematical models that describe the cost of
price of an item as a function of one
independent variables.
e.g., simple linear regression:
multiple linear regression:

PA = C1+ C2
PA = C1+ C2 + C3

Power sizing technique {exponential model}

(CA - CB) = (SA - SB)X

CA = (SA /SB)X

C. SEGMENTING TECHNIQUE
- involves decomposing on uncertain quantity info
parts that can be separately estimated and then
added together. {Hint: use WBS}
- more of a strategy rather than an estimating
model
CE 22 Engineering Economy Developing Cash Flows

Where CA = cost for plant A

same time
CB = cost for plant B
SA = size of plant A
same physical units
SB = size of plant B
X = cost capacity factor
CE 22 Engineering Economy Developing Cash Flows

10

LEARNING AND IMPROVEMENT

- a mathematical model that explains the
general trend of increase worker efficiency and
improved organizational performance with
repetitive production of a good or service.
{experience curve or manufacturing program
function}
Asset specificity
BASIC CONCEPT
- some input resources decrease, on a per
output unit basis, as a function of the number
of units produced.

Zu = Kun
Where:
Zu = the number of input resource units needed
to produce output unit number u.
u = the output unit number
K = the number of input resource units needed
to produced the first output unit.
S = the learning curve slope parameters
expressed as a decimal fraction {e.g., 0.9}

CE 22 Engineering Economy Developing Cash Flows

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